Educational Loans: Dare We Ask Who Benefits from the Subsidy?

Sometimes it pays to ask the right question.

This will be the first of a few postings with the same general theme.  The theme is that often the solution to a problem that policy makers are addressing is totally dependent upon how they couch the question.   

Summary

The US will never get the right level of investment in education and a justified public subsidy to post-secondary education until we eliminate the problem of the free rider. When addressing subsidies for post-secondary education policy makers should first compare who benefits from post-secondary educational loans to who bears the risk of those loans.  If they did, they would realize that analyzing who benefits is a prerequisite to addressing the appropriate level of expenditures for education and the appropriate participation of the public sector.  They would also realize that it is clear that the educational establishment should be bearing some of the risk.

Think Out-Of-The-Box

In many instances we seem to have no problem understanding that loan guarantees represent a subsidy.  For example, during the financial crisis much was made of the subsidy to banks from the implicit guarantee involved in too-big-to-fail.  So, analyses of the subsidy implied by loan guarantees are quite common in political and policy debates. Yet, we seem to be totally unable to view student loans in the same light.  But, that's not the worst of it.

We also know that the benefits of loan subsidies do not all flow to only one of the parties involved.   For example, right now the Republican Party is split on the issue of the import-export bank.  Some libertarian-leaning Republicans are offended by the implicit subsidy to large employers and refer to it as corporate welfare.  The import-export bank finances and guarantees that a purchaser’s debt will be paid.  It is the purchaser’s borrowing that is subsidized, but there is little doubt that the manufactures benefits from being able to sell to a purchaser who might not be able to purchase without the subsidy.  It is the benefit to the producer that results from subsidizing the consumer that we totally ignore when it comes to education.

One does not need to go to policy issues to find evidence that producers benefit from making credit readily available to consumers.  We have numerous examples of large corporations making it quite apparent that they believe they received benefit from loans to customers.  We have no problem understanding that an automaker may choose to loan money to the auto purchaser because of the benefits to the auto company.  Similarly, many large corporations make it a normal practice to loan money to their customers.  General Electric's finance division originally started out with that focus and grew into a totally separate product line.  General Electric is not alone in doing it.  Many other companies from industrial firms (e.g., Boeing and Westinghouse) to consumer products companies (e.g., auto manufacturers and now even Apple) have financial operations designed to finance the purchases of their customers.   We seem to be totally incapable of even asking whether to some extent we should be applying the same logic to higher education. 

Focus on the Complete Problem

Right now there are numerous proposals for how to address the growing levels of student debt.  Every candidate has a proposal; some of which are totally absurd.  Others very successfully address the problem as that particular politician sees it.  Unfortunately, most politicians see the issue in terms of the votes they might be able to gather from different proposals.  If the academic institutions or their unions are strong supporters, the politicians have an incentive to overlook the subsidies’ benefit to producers.  But even if the politicians are not suffering from a conflict of interest, they do not bother to think about what the problem is they are trying to solve. 

The issue of how to fund education gets broad coverage.  The coverage often ignores the issue of who is getting the benefit of the subsidy involved in government loan guarantees.  Even BARON’S magazine in a 9/14/2015 editorial chimed in.  Not surprisingly, the editorial advocated a market solution, “Monetizing HigherEducation: Can Investors Replace Government Lenders?”  The editorial, at least, articulates what it sees as the problem which it summarizes as: “…there’s too much easy federal money floating through the education economy to tempt many students.”  However, as close as that comes to addressing the issue, the thrust of the editorial is not aligning the subsidy with the beneficiaries.  Rather, it just focuses on substituting private-sector money for public-sector funding.

There is some merit to trying to make educational funding more dependent upon voluntary actions instead of the forced contributions of taxpayers.  However, as long as there is any logic for subsidizing education, the market cannot solely support educational funding.  It does not take a lot to undo whatever benefit the market might yield.  For example, the Wall Street Journal on 9/24/2015 in an article entitled “Debt Relief for Students Snarls Market for Their Loans,” reports how thoroughly markets can be sabotaged even by efforts that are designed to have a minimum impact.  It reports that even subsidies restricted to need-based repayment schedules have short-circuited the bond market for student loan-backed securities.  One does not need a vivid imagination to realize that a general subsidy for education could result in even more sub-optimal market performance.

What most people addressing the issue failed to distinguish is whether they are concerned about the amount being spent on education versus who is financing the education.  They are two different issues.  

Consider All the Possibilities

With each possibility (i.e., spending too much or spending too little on education) there are possibilities of some individuals spending too much or spending too little.  Consequently, there are four possible scenarios:

First, we could have a situation where not enough is spent on education, yet those paying for it are paying more than is justified.  Put differently, there is a free rider who is benefiting from education but not paying for any of it.  For example, students and/or the public sector may be contributing more to post-secondary education than is justified by the benefits they receive.  At the same time, the total amount spent on post-secondary education may be less than optimal.

Second, we could be not spending enough on education because no one is spending as much as would be justified.  The benefits from education materialize in a different time frame from the cost.  If there is no mechanism for financing that mismatch in time, education may be underfunded regardless of the magnitude of the benefits.  The BARRON'S piece referenced above addressed the issue of this mismatch in timing by proposing an alternative to public-sector financing.

Third, we could be spending too much on education, yet have some of those who benefit from education not paying what would be justified.  This situation would imply that those not benefiting from education are subsidizing those who do.  The third scenario would imply that an elite that benefits from post-secondary education is forcing the general population and students to over spend on education despite a lack of benefits commensurate with the return.

Fourth, we could be spending too much on education because everyone involved is paying more than is justified.  This would imply broad-based irrational behavior on the part of everyone involved in higher education.  While not inconceivable, it is a very unlikely scenario.

Define the Problem

In order to consider which of these possibilities may exist, one has to establish a definition of what is a justified expenditure for education.  It seems reasonable to say an expenditure is justified if it will return benefits as great or greater than the expenditure.  However, at the individual level, the expenditure is justified only if the return is to the individual or institution making the expenditure.  For example, a student’s expenditures should be roughly equivalent to the benefit the student derives from the education.  Therein lies the rub. 

It is generally agreed that education has what economists refer to as externalities.  Translating the jargon, that means that education has benefits for people other than the individual receiving the education.  For example, there are general benefits to having an educated population.  So, clearly a government subsidy is appropriate.  Almost all societies recognize that benefit and strive to provide universal elementary and, in most instances, secondary education.  To some degree, that same argument regarding general benefits applies to college and postgraduate education.  However, much more of the benefit of post-secondary and graduate-level education is captured by the individuals involved in the process.   So, anyone addressing financing a post-secondary and graduate education needs to look closely at who are the principal beneficiaries.

Prioritize the Issues

When one approaches post-secondary and graduate education from the perspective of the potential beneficiaries, it raises two important questions.  First, are the public-sector subsidies (loans, loan guarantees, grants, and budgetary expenditures) appropriate given the amount of general benefit to society?  After all, we all participate in providing the public-sector subsidies. 

The second question is: are all parties who benefit from the subsidies sharing in the cost of the subsidy to an extent appropriate given the benefit they derive?  While the second question may seem like one of the equity, it is much more important than that.  If there are constituencies which derive substantial benefit from public-sector subsidies without experiencing a commensurate amount of the cost, it will always be in the interest of those constituencies to cloud the issue.  They have a strong vested interest in arguing that the public-sector subsidies are not sufficient. 

It is also worth noting that when there is a participant in the educational process who is receiving benefit beyond their contribution to the subsidy, it introduces an inherent contradiction.  If there is a free rider benefiting from the subsidies, then either less will be spent on education than is justified by its benefits (because the free rider is not paying for the benefits received) or the public-sector subsidies will be inflated beyond what is justified by the social benefit of education (because somebody has to pick up the cost that results in the free benefits received by the free rider).   

Thus, it is fruitless to try to address either the level of educational expenditures or the amount of public-sector money that should be dedicated to post-secondary education without first addressing the issue of how the benefits of the subsidies are distributed.  It helps to set aside the equity issue.  Setting aside equity does not mean that one can ignore the issue associated with having someone who barely got through high school and is struggling to make ends meet pay taxes to subsidize a highly paid professors and the graduate education of someone who will likely have a much higher income. Rather the point of avoiding the equity issue is to focus on the fact that getting the subsidy right is a precondition to simultaneously achieving both the right level of subsidy from the public sector and the right level of total expenditures on post-secondary education.

Not All Subsidies Are Created Equal

Subsidies for post-secondary education can be structured in many different ways.  In fact, the government pursues a number of different subsidy strategies.  In terms of understanding the implications of different subsidy strategies, one should differentiate between subsidizing demand versus subsidizing supply.  Ultimately, the form the subsidy takes will determine who receives benefits.  But, to understand the distribution of benefits, one should first analyze the differences in the impact of the two different strategies.

In a competitive market, if one subsidizes supply and production is allowed to increase, it will increase the quantity available and/or reduce the price.  The relative influence on quantity and price depends upon the elasticity of demand for the product.  In other words, it depends upon whether purchases of the good are sensitive to its price.  With a subsidy of supply, the amount produced is the driving variable with price changes being a response to the increased amount produced.  In a post-secondary education market public subsidies are generally done in order to achieve both objectives (i.e., increase the availability and lower the price of post-secondary education). 

The ability of the educational establishment to constrain supply is the only limitation on the ability of supply subsidies to both increase the amount of education while reducing its price.  Thus, supply subsidies have to be structured in ways that avoid promoting supply constraining institutions.  Accreditors or College Certification Boards, unions, grants based upon inappropriate criteria (e.g., research activities, faculty qualifications, student/faculty ratios) need to be carefully examined, and subsidies should be structured to avoid encouraging them.  In fact, as an alternative to increasing subsidies to education, public policy directed at eliminating supply constraints created by the educational establishment should be considered.

By contrast, if one subsidizes demand in a competitive market, the increased demand will drive up prices and, depending upon the responsiveness of supply, increase production.  Since increasing the price of post-secondary education is seldom considered a worthy objective by anyone other than the educational establishment, government subsidies should focus on increasing the supply.  This is a marked contrast from the US emphasis on student loans as a solution to the increased cost of higher education.  The problem is that politicians cannot resist the ability to control who they make post-secondary education available to.  The very fact that control is so prized by politicians is an indicator that deficiencies in demand are not a problem.  By subsidizing additional demand they just ensure that the demand will outstrip supply and increase prices.

The Role of Educational Loans

Given the differences in the impact of subsidizing supply versus subsidizing demand, it would seem appropriate for the government to significantly scale back its subsidies to higher education that take the form of student loans.  At the same time, it is clear that there is a need for a mechanism to finance the difference between when the costs of higher education are incurred and when the benefits are received.  It is not automatically apparent that the public needs to be directly involved in that financial transaction.  It would seem far more appropriate for institutions of higher learning to assume some responsibility for financing the demand for their product. 

A public-sector subsidy is still appropriate to the degree that education benefits the general public to a greater extent than would be financed by the private sector.   If supply subsidies are judged inadequate, the public-sector subsidy could take the form of loans to the institutions of higher learning.  Those loans could be commensurate with the amount the institution of higher learning loans to students.  This approach would meet the financing requirements.  It would also allow the students to assume responsibility for costs that will result in future benefits they will receive. 

At the same time, it would leave responsibility for loss on the loans with the institutions that derive substantial benefit from having demand subsidized.  If the post-secondary education does not result in enough benefit to enable the student to pay back the loan, the institution that provided the education should accept responsibility for its failure.

There might be a concern that some colleges would choose not to participate in the program (i.e., some colleges may choose not to borrow the money).  But all government subsidies designed to increase the supply of education could be made contingent upon participation in the loan program.  It can also be made a requirement for certification from the accrediting organizations and College Certification Board.  Student loans have a role in making post-secondary education available to those who might otherwise not be able to afford it.  For that reason alone, the public sector would be justified in denying any subsidies to institutions that did not participate in the program.

It is worth noting in passing that there is no reason why the government would have to require that student loans from the institution exactly match what they borrow.  A condition of the loan to the institution could be that half of it be used for student loans or could equally feasibly be that two dollars in student loans are required for each dollar of borrowing.  Starting out with the match would seem reasonable, but over time one would expect that the ratio could be fine-tuned.  The very process of fine-tuning would be a way to address the need to simultaneously fund adequate post-secondary education and match the public-sector expenditure to the benefit that the general public derives.  It should be noted that this approach could be tried by any state that has student loan programs. 

The Urgency

This it is not a problem that can be ignored.  First, as is widely reported, there is intense pressure on political candidates to make all sorts of unreasonable promises regarding how they will address the student loan problem.  Not surprisingly, as good candidates, they are making such promises.  The danger is they may try to fulfill those promises.  That politicians want to address the student loan problem would be good if their proposals reflected a thorough understanding of what the problem is, but that is hardly the case.  Their approach seems to be, when something is not working spend more on it. Wall Street Journal investigation that found that in a single year the government sent $16 billion in aid to students at four-year colleges that graduated less than one-third of their students within six years.  The basic structure of student loans needs to be rethought.

Second, as noted in an opinion piece in the Wall Street Journal entitled “Washington’s Revenue Windfall” (8/18/2015), “The Congressional Budget Office … cites a $30 billion, or 51%, spending increase for the Department of Education—‘mostly because of an $18 billion upward revision in the estimated net subsidy costs of student loans and loan guarantees issued in past years.’  The opinion piece’s conclusion is that the government’s “takeover of the student-loan business is costing far more money than advertised, probably due to growing defaults.”  Clearly, there is a budget issue and the risk that the cost of student loans will crowd out other worthy expenditures.

Third, the government is accumulating a huge potential liability that could become a mandated future expenditure. As has been reported in the Wall Street Journal for example in “Duncan Puts Pressure on Colleges” (10/21/2015), “…as student debt has climbed to $1.2 trillion, but graduation rates remain not much better than a “coin toss,” Mr. Duncan has said.  Mr. Duncan is the Education Secretary.  The concern is not the rant of an outsider seeking to undermine education.

Fourth, the misplaced incentives created by the current system are widely recognized.  For example, Mr. Duncan in the article cited above states: “government, at both the federal and state level, along with accreditors and Congress, need to flip the current incentives in higher education,” Mr. Duncan said. “In the current system, only students, their families and taxpayers lose when students do not succeed. That simply doesn’t make sense.”  Currently, about one in every five student loans is in default.  Students, families and taxpayers are being asked to bear burden of debt beyond their financial capabilities.

Finally, and most importantly, the ability of the US to compete in a global market will depend upon it being able to generate an educated, productive labor force.  That can only be done if all participants in the process are contributing appropriately to the success.  It seems to an outsider that the only impediment to achieving that objective is a vested interest of the current free riders benefiting from the subsidies the public-sector must supply to the post-secondary educational industry.  So, it is time for the educational establishment to step up to the plate and recognize that they have to take some responsibility for the value of their product if they expect public-sector subsidies to continue.  Having post-secondary educational institutions accept the risk associated with the return on the investment in post-secondary education would be a good start.

Getting History Right

Lumping the stimulus and bailouts together is a mistake

In “Don’t Look Back in Anger at Bailouts and Stimulus” (WALL STREET JOURNAL, Opinion, Oct. 15, 2015) Alan S. Blinder and Mark Zandi provide a valuable service by trying to sort out fact from fiction surrounding steps taken during the financial crisis.  They are undoubtedly correct in their subtitling of their opinion piece: “Without the emergency measures of 2008-09, the U.S. economy would be far worse off today.”  However, they do a disservice by lumping together monetary policy initiatives and fiscal policy initiatives and not separating them from initiatives directed at financial stability.

It pays to look at each separately.  Part of the authors’ motive for writing the opinion piece is the difference between the public's perception of the initiatives versus the actual impact of the initiatives.  Given that focus, it seems reasonable to start with the initiatives directed toward financial stability since they seem to be the subject of the most marked misinterpretation.

If one were to pick a poster child for misinterpretation, it would be TARP.  As such, it can be representative of the initiatives to promote financial stability.  It is worth noting, however, that TARP was only one of many programs directed toward financial markets.  They range from other asset purchase programs to extension of FDIC insurance to non-bank liabilities such as money market funds.

All of them had as their guiding principle Bagehot’s dictum regarding the appropriate central bank posture during a financial panic.   The dictum is often summarized as lend freely at a high rate of interest on good banking securities.  Following the dictum is essential to the central bank’s roll as lender of last resort.  Those who object to the Federal Reserve's role as a lender of last resort would benefit from a fuller understanding of the context in which the dictum was developed.  The dictum was designed to provide guidance for ending a financial panic, but quoting it just in that context without noting the full statement is a disservice.  A more accurate characterization would add “and you are sure to make money.”  One should keep in mind that when Bagehot wrote LOMBARD STREET: A DESCRIPTION OF THE MONEY MARKET (1873) he was addressing the operation of the Bank of England which was a profit-making institution.  The advice was not designed to bailout anyone: it was designed to end panics and make money in the process.

Consequently, as early as October 2, 2010 it was possible to write a posting for The Hedged Economist entitled “TARP: A ,success not being acknowledged.”  That posting could cite data that made clear that efforts to ensure financial stability were far from a bailout.  Clearly, they were going to make money for the US government's Treasury.  Those who stick with the bailout terminology are clearly under the false impression that loans, regardless of the terms, represent a subsidy of some sort.  Lending money to individuals or organizations who can provide collateral and pay it back with interest is simply good business, not a subsidy.

Separating out monetary policy also clarifies who is receiving benefits.  Lumping zero interest rates and quantitative easing in with the TARP loans is absurd.  The principal beneficiaries of zero interest rates and the lower long-term interest rates generated by quantitative easing can legitimately be described as having been bailed out.  They have been bailed out in the sense that they are the beneficiaries of zero interest rates. 

Financial institutions are hardly the major beneficiaries of zero interest rates.  After all, the regulations under which they operate guarantee that they will hold a substantial amount of the low-interest government debt.  The WALL STREET JOURNAL on 10/15/2015 in an article entitled “$1.17 Trillion at Zero Percent Interest” pointed out: “Investors are handing the federal government a lot of free money.”  If anyone is being bailed out by zero interest rates, it is the federal government.  The near zero interest rates give the federal government the option to borrow the money that they lent to financial institutions at a profit.  Granted, the government could just as well have printed the money, but zero interest rates gave them an additional option.

It would be very easy to lose sight of the macroeconomic role of monetary policy by pursuing a totally useless witch hunt for who benefited from zero interest rates.  It is worth noting, however, that it is widely recognized that the macroeconomic benefits of expansionary monetary policy are often purchased at the expense of the banking industry.  The banking industry's current net interest margins strongly reinforce the impression that the benefits of expansionary monetary policy occur despite their negative impact on the banking industry.

Lumping the financial and monetary policy initiatives in with the fiscal policy effort is even more unfortunate.  The fiscal policy initiatives that spanned two administrations constitute a mixed bag even when taken alone.  The Hedged Economist spent all of September 2010 on postings addressing fiscal policy.  At the time, it was appropriate to refer to them as a failure.  But, they were a failure in terms of their own definitions of success.  They were not a failure in the sense of having no merit.

Alan S. Blinder and Mark Zandi provided one of the better analyses of the potential impact of the fiscal policy efforts.  At that point, their analysis was projecting what they felt the impact of the fiscal initiatives would be. Their analysis was the subject of postings on the Hedged Economist on 9/15 and 9/28/2010.  The postings explained reasons to believe that they were overestimating the impact.

At the time it seemed they were overestimating the potential impact.  The reason for feeling that was the case is summarized by the quote below, especially the portion of the quote highlighted in bold type:

“My concern is that the public will judge the effectiveness of fiscal stimulus by the Recovery Act. Stimulus started with Bush's approximately 200 B tax rebates to middle and lower income tax payers. But, the total over the two administrations is going to come in being well over a trillion dollars, probably in excess of $10,000 per household. Some partisans will also stick in any deficit and come up with multiple trillions….From my perspective, the issue is whether the multiplier stays linear as the size of the stimulus grows.”

If the quote seems questionable, consider this: the opinion piece makes a comment that “But it was no coincidence that the Great Recession ended in June 2009, just four months after the Recovery Act’s nearly $800 billion-plus stimulus package was passed.”  It is clearly falling into the trap of assessing the fiscal measures as if the Recovery Act was the only fiscal initiative.  Further, while it contends that it is “no coincidence” that the recession ended four months after the Recovery Act, it fails to explain how the Recovery Act could produce that result before it had been implemented.

One does not have to disagree with their belief that fiscal stimulus contributed to the recovery.  Even if one agrees, as I do, that the beneficial impacts of fiscal policy are real, it is clear that demonstrating that relationship is far more complicated and subtle than recognizing the success of financial and monetary policy.  Further, the cost benefits analysis of fiscal stimulus is different from an acknowledgment that there were some benefits. 

Consequently, it would benefit Alan S. Blinder and Mark Zandi’s efforts to ensure that history gets this right, if they would focus on the most obvious successes.  That is especially true given that the most obvious success is the financial stabilization effort, and it is also the one most frequently mischaracterized as a bailout.  Fiscal stimulus has a natural constituency among liberals.  Monetary policy similarly has a constituency among monetarists.  But the only constituency for the financial stabilization efforts is the facts.

BHP Billiton stock’s role in a dividend growth portfolio

It provides exposure to resource prices, foreign exchange markets, foreign stock markets, and indirectly to developing economies

The impact of the strong dollar on BHP Billiton is complicated and easy to underestimate: its output is priced in dollars.

Thus, there are numerous reasons to think the stock is attractive now, including the price of the stock

As a leading global resource company, BHP Billiton is widely followed and well-known.  BHP Billiton trades under two symbols BBL and BHP.  Which is the most attractive investment for an individual depends on tax considerations which are beyond the scope of this posting.  Rather, throughout this posting the reference will be to BBL since it is the appropriate vehicle for most US investors.  Because BBL is so well known, this posting skips doing a detailed description of the company.  However, a few things are worth noting because they relate to the thesis of this posting. 

BBL is actually in two businesses.  One is the operation of extractive activities (mines and wells).  The second is the allocation of capital across the development of those resources including the acquisition and sale of those mines and wells.  The company's history would suggest that it is good at both businesses.  One might argue that there is a third activity: acquiring the right to develop the resources, but as is done above, it is equally legitimate to just consider acquiring rights as a part of acquisition and sale of those mines and wells.

Commodity prices can fluctuate over long cycles where the change in prices can be quite substantial and open to being confused with a trend.  At the same time, commodity prices can react violently over very short periods of time.  Nevertheless, BBL has been able to maintain a reasonably stable dividend.  Yet, the instability in commodity prices and the consequent fluctuation in the price of BBL’s stock deters some dividend growth investors.  The thesis of this article is that BBL provides diversification that belongs in a dividend growth portfolio, and now is a good time to add that diversification.

Many dividend growth stocks are consumers of natural resources.  That is less true of the pharmaceuticals and consumer staples than the industrials.  BBL’s exposure to resource prices is the opposite of many industrial firms and thus provides a mild hedge.  It is only a mild hedge because the same economic prosperity that affects industrial demand can also affect the demand for resources.  However, the lead times for developing extractive resources are quite different from those associated with investments in industrial activities. Therefore, commodity cycles can develop independent of the business cycle.

For US investors, BBL also provides access to foreign stock markets, a form of diversification recommended by many financial advisors.  If unhedged for the foreign exchange risk, it provides diversification across currencies.  Also, developing economies are often the major consumers of natural resources.  Thus, BBL provides exposure to developing markets indirectly. Consequently, BBL’s stock can be quite volatile, but overlong holding periods it is not highly correlated with general market volatility.  The beta for BBL is less than one (about .9).  Thus, despite the volatility of BBL’s stock price, it can work to stabilize a portfolio.  The volatility in the stock's price means that the timing of purchases is very important.

BBL is a global company with operations in many countries.  Its Australian mining operations are often the focus of analyses, but they are hardly the totality of the company.  That is an important consideration because, as a multinational, BBL is operating in many different currencies.  It also develops a broad range of extractive resources, and the prices of most of the commodities BBL develops are quoted in US dollars.

A recent analysis of BBL on SeekingAlpha focused on iron ore prices, “BHP Billiton: A High-Yielding Wait For The Iron Ore Turnaround.”  This is very good analysis covering both the company's current strategy and the stock’s valuation with a good description of why iron ore is becoming increasingly important to BBL.  However, when reviewing the analysis, one should keep in mind that iron ore prices are presented in US dollars.  The strong US dollar means that, while iron ore prices may continue to drop for US consumers, they could simultaneously rise in weak currencies because of the dollar’s affect.  As pointed out above, that is true of many of the resources BBL develops.  They are priced in international markets in US dollars.

The dollars affect could benefit BBL in a number of ways.  First, when it comes to operating their businesses, they may produce and sell in areas where the currencies are weak relative to the dollar.  At the same time, their pricing is based upon the dollar.  Thus, they reap the benefit of operating in weak currency environment without the pressure of having to sell priced in that weak currency.  In terms of the spread between their cost and their prices, the foreign exchange impact is as if they produced in weak currency and sold in a strong currency country.  Second, since they operate in multiple countries, they can gear down or sell operations in strong currency environments and gear up in a weak currency environment.  At a global level that will reduce their cost. 

Because the currency effects are secondary to the issues addressed in the analysis in the article cited above, they often get ignored.  Many investors will just trust the management of the company to navigate the issues associated with currency fluctuations.  In the case of BBL, the inclination is to recognize the management has negotiated currency fluctuations in the past and assume that they are continuing to do so.  Further, there continue to be indications that faith in BBL's management is justified.  For example, the article cited above mentions that BBL is exiting its low margin coal business in South Africa, but unlike some of the other divestitures, it is not exiting the coal business.  Rather, it is just adjusting which assets it retains in which countries.  Similarly, BBL is gearing back its exposure to oil and gas in the US at the same time it is analyzing the desirability of increasing its exposure in oil and gas in Mexico.

In summary, for US investors a strong dollar will make the dollar price of BBL’s lower, but the company’s performance should not be adversely affected by the strong US dollar.  In fact, the company may actually benefit from the strong US dollar.  The company operates in so many countries that it is probably best to just view it as operating in an environment of multiple countries with weak foreign currencies.  Those countries include both the sources (i.e., points of production) and markets for BBL.  The net effect is that it is a multinational company that is not adversely affected by the US dollar.  It is producing in weak currency countries and selling at prices quoted in a strong currency.  Many dividend growth stocks are going to be adversely affected by the strong US dollar.  Thus, BBL may offset some of the negative impact.

A previous posting on the Hedged Economist (Rebalancing and Risk) discussed selling two international stock mutual funds that had been long-term holdings and shifting to individual stock positions where the foreign currency risk was easier to understand and more appropriate given the rest of the portfolio.  BBL fits that description perfectly.  That BBL is a potentially good fit in a dividend growth portfolio has been true for quite a while.  However, because the stock fluctuates with commodity prices and foreign currency rates, prudence required waiting a number of years until it became attractive.  The combination of the strong dollar and the overreaction to the commodity cycle has finally made it an attractive purchase. 

Unlike the author of the SeekingAlpha article entitled “Recent Buy: BHP Billiton PLC,” I did not try to average in.  The reasons for thinking it is attractive are the same as those discussed in the article (PE, yield, restructuring, etc.).  Nevertheless, perhaps out of frustration after waiting for a number of years for the opportunity, a need to maintain international exposure, or just out of overconfidence, when the stock was under $44 it seemed to justify making the entire planned purchase.  BBL now has my targeted portfolio weight and contributes my targeted portion of the dividend flow from my portfolio.  At $44 a share, that has been accomplished at a reasonable price.  However, both in terms of portfolio benefits and the stock’s valuation, purchases at any price under $50 seems justified.

Sysco (SYY) Belongs On the Dividend Investor’s Watch List

It has an attractive dividend history

It will benefit from low energy prices

It is emerging from the cloud of merger uncertainty

Earnings need to improve in order to justify current stock prices

Its US focus is attractive and could offer portfolio benefits

As one of the dividend aristocrats, Sysco is, or has been, in the portfolio of many dividend- growth investors.  The company’s failures to produce earnings growth as well as high price earnings ratio have probably taken it off the radar of many dividend-growth investors.  However, there are reasons to keep the stock on one's watch list.

An article on SeekingAlpha entitled “Sysco: Plunging Gas Prices, US Foods Merger Will Benefit The Company” illustrates the issue.  It points out the benefit that Sysco could derive from lower energy costs and its merger with US Food.  However, it goes on to point out that by many metrics Sysco's stock is overpriced.  Looking just at those factors, the merger with US Food would have to be a significant catalyst for improvement before the stock would become appealing.  That certainly is a possibility, but without some evidence that it is occurring, it alone is not a convincing investment thesis.  It justifies watching the company's performance but not necessarily purchasing a significant position in the stock.

However, there are other reasons to consider Sysco.  The SeekingAlpha article focused on the benefit plunging oil prices would provide as a result of Sysco’s energy consumption.  That reduced cost to the company could improve profits and margins.  There is another impact that the market may be overlooking.  That is the influence of energy on the demand for Sysco's services.

Food away from home, the source of demand for Sysco’s services, is influenced by energy prices in two ways.  Reduced gas prices lower the cost to the consumer of going out.  The cutback in driving associated with high energy prices usually focuses on long trips, but it probably also influences local discretionary driving such as going out to eat.  Lower gasoline prices would reverse that impact.  Second, the US consumer is a major beneficiary of reduced energy costs.  As a discretionary purchase, food away from home will be a beneficiary of the increase in discretionary income of consumers.  A previous posting entitled “Markets in Motion” expressed some skepticism about analysts’ estimates of the impact of oil prices on earnings.  Specifically it stated: “While the energy sector’s earnings will be reduced, earnings in some other sectors will benefit.”  Sysco is an example of the company that could be a beneficiary.

The current raft of earnings reports where negative currency translations have resulted in earnings that disappointed investors has probably provided an investor with an intuitive understanding of what generalized foreign currency exposure means.  For anyone who still does not understand why foreign currency exposure is important, a quick reading of two recent WALL STREET JOURNAL articles should help.  “Swiss Franc’s Leap Lifts Some FX Brokers” on Monday, January 26 and “Currency-Trading Volumes Jump” on January 28 both make mention of the amount of money involved in currency trades.  When more than $4 trillion (note that's trillion with the t) is flowing in a single day, it will easily overwhelm any actions taken by the management of any corporation.  Sysco's US focus means it is not as exposed to currency risk as many other corporations.

At the same time, there is a potential benefit to Sysco from the strong dollar.  A strong dollar will reduce the price of imports.  Consumers of imports, US citizens for short, will be beneficiaries of those lower import prices.  That will increase their discretionary income which could benefit Sysco if it results in increased demand for food away from home.

Reduced cost as a result of lower energy prices, reduced risk as a result of its US focus, and the economic tailwinds that could result in an increase in demand for Sysco's services, are all factors that will take time to have any impact on Sysco's profitability.  So, it would be a bit naïve to expect them to have their major impact on the upcoming earnings report.  They might, but waiting for the earnings report and carefully examining it for any indication that these factors are starting to show is a viable strategy.  There is a difference between operating in an economically beneficial environment and actually benefiting from it.  The latter requires that management capitalize on the beneficial economic environment. 

Despite the cautions above, I have initiated a position in Sysco due to portfolio considerations. A previous posting entitled “Rebalancing and Risk” discussed why an investor might want to reduce his or her exposure to generalized tail risk. It focused on mutual fund holdings and on tail risk.  However, even without tail risk, many investors, especially those seeking dividend growth, may have significant exposure to a large number of multinationals.  As a consequence, they may have taken on a substantial amount of generalized foreign exchange exposure.  That would not be the case if one is loaded up on REITs, pipelines, US banks and utilities.

However, a previous posting, “The Widows’ andOrphans’ Portfolio and US Banks,” presented a core portfolio for a buy-and-hold investor.  With the exception of Verizon, all of the holdings are multinational.  As a core portfolio, many of the stocks have been held for a long time (decades) and represent significant portions of the total portfolio.  Also, the posting suggested that an investor, at least this investor, might want to avoid regulatory risk.  It is difficult to find utilities and banks where the regulatory risk is acceptable.  Even pipelines and some REITs have regulatory risk. As consequence, many of the non-core holdings are similar to those discussed in the posting.

Investors can find themselves in a position of searching for domestic exposure that is relatively “regulatory risk free."  Sysco is such an investment.  There is no magic formula that can tell the investor how much of their portfolio to shield from foreign exchange fluctuations or, for that matter, regulatory risk.  With only 10% of my portfolio distributed across seven stocks that are primarily domestic in their orientation (NNN, GAS, HCN, WTR, WFC, TRP, VZ) Sysco is appealing from a portfolio perspective.

Given that conclusion, two issues remain: what role will it play in the portfolio, and when and how should it be acquired.  Regarding the first issue, a SeekingAlpha article entitled “Modern Graham Quarterly Valuation Of Sysco Corporation” provides pretty good guidance on what role it should play.  It will not be a core holding, but it is not totally a speculation.

Timing the acquisition of any stock is always an issue.  A good stock at a bad price is not a formula for success.  Thus, acquiring some of the intended position ahead of earnings may work for some investors, but given the economic tailwinds that could benefit Sysco, putting it on a watch list and examining its earnings release closely is a justified use of time for many investors.  The company has become very interesting again.

The Canadian central bank’s rate cuts should put TD Bank on US investors’ watch lists.

TD has many of the characteristics of a quality dividend growth stock

US investors can hold TD shares without incurring direct foreign exchange risk

As a bank with significant operations in both Canada and the US, the weak Canadian dollar could benefit TD bank.

The Canadian central bank’s rate cuts enhance TD’s appeal

A recent (Jan. 16, 2015) article on SeekingAlpha entitled “Toronto-Dominion Bank Analysis Points Toward Growth," provided a general summary of the advantages of TD bank as a growth story for investors considering a Canadian bank.  Rather than repeat that discussion, this posting focuses on characteristics of TD bank that should resonate with US investors.

However, before focusing on characteristics that should be important to US investors, the article makes a point that should be relevant to all investors: “TD's latest report shows profit continuing to be made, but falling shy of analysts' expectations, which those analysts deem a signal of stagnation. Reuters's data predicted $1.05 in earnings per adjusted share and $1.00 per share of net income, but were disappointed when faced with 98-cent profits per share and a 91-cent per share of net income. With these results came a 2.71% decrease in stock price that same day.”  

For short-term investors, missing an estimate is justification for selling, but often for a long-term investor it is an opportunity to purchase a stock that is temporarily depressed because of the short-term focus of many other investors.  I view it in the latter sense and increased my holdings of TD at 10%.  Less that be interpreted as an effort to try to time the market, the balance of this posting focuses on the other reasons for purchasing TD bank shares.  Thus, the earnings miss just influenced the timing of an investment that was planned for a variety of reasons, including the company's long-run prospects as indicated by its fundamentals and portfolio considerations.

For a US investor, the most compelling reason for considering Canadian banks remains the issue discussed in a March 5, 2014 posting entitled “The Widows’ and Orphans’ Portfolio and US Banks.”  If possible, one would want some representative of the financial sector included in a portfolio for diversification.  Canadian banks are subject to far less regulatory risk than US banks.  Reading about and receiving notices concerning lawsuits against you as a stockholder gets tiresome, and one should avoid it if possible.  

When addressing any investment in Canada, the US investor has to keep exchange rates and energy prices in mind.  A good illustration occurs in an article published on January 16, 2015 in the WALL STREET JOURNAL.  It was entitled “What’s the Matter With Canada?” The major thrust of the article concerns Canada's manufacturing sector, but it was impossible for the article to thoroughly address that issue without discussing the impact of oil prices on the Canadian dollar.  The same is true when looking at Canadian banks.  It is how energy prices and exchange rates relate to TD bank's business profile that makes it an appealing investment for US investor who is choosing among Canadian banks.

The first thing to note is that foreign exchange rates do not influence the desirability of TD bank's shares in the same way they would many other Canadian companies.  The shares on NYSE are not ADRs. They are a special class of interlisted securities.   That is true of many Canadian banks. You are buying US shares directly, not ADRs.  So, the US investor is not exposed to foreign exchange risk in the actual price of the stock. 

For TD bank, the advantage of listing on several exchanges is that it allows the company's shares to gain access to more investors and increases a company's liquidity.  The shareholder is exposed to the sentiment of investors in multiple countries.  Thus, the TD bank shareholder has exposure to a foreign stock market without the direct foreign exchange risk.  It is diversification across markets without direct foreign exchange risk in the price of the stock.

Similarly, the US investor holding any Canadian bank has diversified their portfolio to include exposure to a non-US economy.  That is true of any international company whether headquartered in the US or a foreign country.  In the case of TD bank, that exposure is easily quantified: 25% of the bank's retail bank earnings come from the US, 65% come from retail banking in Canada and 10% come from wholesale bank.

Looking at the correlation between the US and Canadian stock market and economies, one sees that the diversification benefit exists, but it is weak.  From the portfolio perspective, that weak diversification across stock markets and economies when combined with the diversification benefit of being able to hold a bank stock without the regulatory risk provides the basis for putting TD bank on one's watch list.

What is important is how foreign exchange rates will affect the profits of TD bank.  TD bank is the fastest-growing Canadian bank. It has a presence outside of Canada that is as large, but not as profitable as its Canadian base. It was the American side of business that specifically concerned analysts.  While only 25% of the bank's retail earnings come from the US, it represents a much larger portion of the bank's retail operation (about 50%) when measured by number of branches.

That TD bank earns a lower return from its US branches is not surprising.  TD bank is essentially exporting services into one of the most competitive banking markets in the world.  It is easy for Canadians to overlook the fact that in the US all one needs is to have 10 bucks and a politician in your pocket, and you can open a US bank.  That TD has been able to compete in that market and maintain overall returns that are competitive with other Canadian banks is very much to its credit.

Like many exporters that have their production facilities in the country where they sell the product, TD bank benefits from the international operation through its impact on its earnings when translated back to its native currency.  In Canadian dollars that 25% of earnings that originate from US operations will increase without any increase in the efficiency or scope of the US operation.  It is, if you will, the opposite of the foreign currency translation that will negatively impact many US multinationals.  From the US investor’s perspective, it is an opportunity to invest in a situation where the strength of the US dollar benefits the holding.

Just as foreign exchange developments justify putting TD bank on one's watch list, energy market developments also justify giving TD bank a close look.  TD bank's footprint is far less affected by energy prices than most Canadian banks.  In the US, TD branches are located in areas that benefit from lower energy prices.  Thus, the retail customers they serve are benefiting and should be better bank customers.  Also, the bank is not overly exposed to commercial loans to the energy sector.

TD bank has relatively limited exposure to the current slumping oil market.  It would be a mistake to view that as just avoidance of a negative situation.  In fact, it creates a very positive environment for TD bank.  The central bank of Canada just cut interest rates which should guarantee that the favorable foreign currency affect discussed above will grow. 

At the same time, one of the concerns regarding Canadian banks is the potential that Canada is developing a housing bubble and a consumer debt bubble.  The lower interest rates that are the central bank’s response to the impact of energy prices on the Canadian economy should, at least temporarily, mitigate any impact of the perceived bubbles.  However, the US investor is aware that the bubble in the US housing market was a product of our institutional framework.  No similar chaotic institutional pursuit of serving consumers who want to increase their leverage seems to exist in Canada.

Lower interest rates are generally viewed as unfavorable to banks.  They pressure the interest rate margins.  However, as discussed in a SeekingAlpha article entitled “Surprise rate cut not yet feeding through in Canada,” TD has not immediately respond by lowering its interest rates.  Until they do, the impact on interest rate margins will not show up. 

It is important to keep in mind that for 50% of TD bank's retail operations, US interest rates are equally important.  If the US central bank raises interest rates as is expected, interest rate margins on the US portion of TD bank's operations could improve.  That improvement would occur at the same time that a strengthening dollar is making the earnings of US operations appear more significant in Canadian dollars.  The divergence between the policies of the central banks of Canada and the US should ensure that the benefit to TD bank persists for a while.

In summary, TD's appeal applies to both Canadian and US investors to the extent that it results from the interaction of its geographic footprint and the effect of a weakening Canadian dollar.  What is unique from a US investor’s perspective is the ability to diversify across stock markets and national economies without incurring foreign exchange risk directly.  When that diversification risk is added to the ability to avoid the regulatory risk embodied in US bank stocks, it makes TD bank an appealing alternative.  That the impact of a strengthening dollar on TD bank's earnings could be the opposite of the impact of the strengthening dollar on other holdings of multinationals just adds to its appeal.

Rebalancing and Risk

What is tail risk and how does it relate to the stability of the correlation matrix? 

How does it interact with rebalancing?

Is it possible to identify the benefit one gets from rebalancing based upon market developments?

How do oil price fluctuations and foreign exchange fluctuations relate to the benefit of rebalancing?

What are the implications for a US investor’s international holdings?

This posting advances the notion that instability in the correlation matrix is indicative of a rise in the potential tail risk.  Further, the potential for tail risk should inform an investor’s approach to rebalancing his or her portfolio.  The conclusions drawn in this posting may be unique to market fluctuations caused by oil price and exchange rate instability.  The posting does not attempt to look beyond potential consequences of oil price and exchange rate instability.  It concludes by looking at the investment implications of the central thesis regarding the relationship between the correlation matrix and potential tail risk.  Not surprisingly, the conclusions regarding the implications vary dependent upon one's home currency.  This posting focuses specifically on the implications for US investors.

In finance, “risk” is usually equated with volatility.  Sticking with that definition, tail risk would be extreme volatility.  It is important in financial markets because of the phenomenon known as the fat tail: basically, the probability of an extreme event is higher than what one would assume from a normal distribution.  According to that definition, tail risk is just the same as “risk.”  It is the probability that makes it significant.

A second definition of tail risk is a low probability event that has huge consequences.  The second definition does not quantify low probability.  Instead it focuses on the magnitude of the consequences.  However, it is silent on whether those consequences are the volatility of the variable concerned or some other event that is triggered as a result of the low probability event.  Volatility of the variable is illustrated by a tendency for the amount of change to go exponential when it approaches an extreme.  Triggering of some other event is illustrated by, for example, an extreme change in the price of a commodity forcing a government to default on its loans.

The final candidate as a definition of tail risk considers a phenomenon in finance that is extremely important.  It combines elements of the two previous definitions.  It is associated with, and perhaps a consequence of, extreme volatility.  When there is extreme volatility, it is often accompanied by a breakdown in the relationship between different financial assets.  In financial jargon, the correlation matrix breaks down. 

Being statistical measures, how well things are correlated are not a constant.  They fluctuate.  Thus, while a breakdown in the correlation matrix is often associated with tail risk as defined in the first and second definition, it also sometimes occurs without the realization of tail risk.  A breakdown in the correlation matrix can be viewed as a necessary-but-not-sufficient condition for tail risk.

This last definition based upon the stability of the correlation matrix has the advantage that it provides room for recognition of the fat tail of the distribution of  returns and it defines “the event with huge consequences” in terms of financial market performance.  More importantly, tail risk usually proceeds quickly.  By contrast, deterioration of the correlation matrix can be seen before it completely breaks down.  Thus, one can view the deterioration in the correlation matrix as a continuous variable that will change going into a tail risk event as defined in the first two definitions.

The previous posting, “Markets in Motion,” talked about the market volatility in oil prices and foreign exchange rates.  Both phenomena raise the probability of tail risk by all three definitions discussed above.  Historically, extreme foreign exchange rate fluctuations have been associated with equally extreme economic and financial events.  The reason for the extreme importance of foreign exchange rates is simple.  Foreign exchange rates feed through both to the stability of the financial system and the performance of the underlying economies.

Many financial advisors recommend rebalancing a portfolio regularly.  The end of the year or the beginning of the new year is a convenient time for financial advisors to include a reminder about rebalancing.  There is no magic associated with annual rebalancing, but the change in the calendar does provide a convenient marker for financial advisors or investors who need a reminder. 

Rebalancing a portfolio is often presented as a way for an investor to reduce risk that may have developed as a result of differences in performance of different assets.  However, in fact,rebalancing does not necessarily reduce or increase the risk in a portfolio.  Whether it increases or decreases the risk depends upon what assets are being sold and what are being bought.  (Technically it depends upon the volatility of the assets being bought and being sold).  The real reason for rebalancing is to keep the risk-return profile stable at some level initially set to represent the investor’s risk tolerance. 

A previous posting entitled “Does AlgorithmicTrading Make Sense for Small Investors?” discussed the limitations on some of the assumptions associated with the approach when applied across asset classes.  Instability in the correlation matrix was one of the limitations mentioned.  So far, the phenomena discussed in “Markets in Motion” have not resulted in tail risk in this sense, at least not for US investors.  Consequently, for a US investor, rebalancing seems to have achieved the desired results so far in 2015.  For example, as stock prices declined, bond prices increased. (It is worth noting, however, that when one takes a global perspective, rebalancing has not worked for investors in every country). 

However, when examined closely, it can be seen that rebalancing appears to have achieved the desired objective, but that appearance is due to returns.  The point of "Markets in Motion" was that the phenomena being discussed, oil prices and exchange rates, have increased volatility of all assets.  The portfolio’s overall risk has changed if the change in the volatility of different asset classes is not uniform.  It seems naive to assume that the volatility of all asset classes is changed in the same way. 

In order to achieve a rebalancing that maintains the risk-return profile, one has to forecast not just how returns vary with fluctuations in oil prices and exchange rates, but also how volatilities of each individual asset class is changed.  In and of itself, the fluctuations in volatility may make any portfolio of financial assets more risky.  That is true if the fluctuations in oil prices and exchange rates increase the volatility of all asset classes.  It is also conceivable that it would reduce the risk. 

To illustrate using just using US stocks and bonds, in 2014 the returns on stocks and bonds can be represented as follows: the S&P (NYSEARCA:SPY) delivered 13.5%, a broad-based bond index (NYSEARCA:AGG) delivered 6%, long-term Treasuries (NYSEARCA:TLT) delivered 27.3%.  Thus, a portfolio of stocks, bonds and Treasuries would be rebalanced at the end of 2014 by selling Treasuries and increasing stocks and non-Treasury bond holdings.

One way to view that rebalancing is to believe that during 2014 the increase in the value of Treasuries reduced the risk in the portfolio to the point where rebalancing into stocks and bonds was needed in order to restore it to a given risk-return profile.  In other words, the rebalancing is needed to restore the risk that was eliminated in the portfolio by the increase in the weight of the Treasury component.  The alternative is to view the volatility associated with a higher returns to Treasuries as implying that they are more risky than they were going into 2014.  In this view, Treasuries are now viewed as an asset with greater risk than they had at the beginning of 2014.  Selling the Treasury reduces the risk because Treasuries have become more risky assets. 

One could argue that because an investor must anticipating the impact of oil and exchange rates on two variables (the level of asset prices and their volatility) it has introduced additional uncertainty.  That is a real source of increase in risk, but it is not potential of tail risk.  The important change in the risk associated with any portfolio becomes apparent when one adopts a definition of tail risk that involves only financial assets.  For the US, it is reasonable to assume that the increase in the price of Treasuries has increased their potential volatility.  It is easy to dismiss that as just true of any asset that gains significantly in price.

However, one should keep in mind that a significant portion of the increase in the price of Treasuries is a response to foreign exchange fluctuations.  In short, foreign exchange rates have made Treasuries more risky by increasing their price.  But again, that is just normal portfolio adjustment.  Once one starts to think in terms of global investors, one has to realize that each investor has an investment option that is analogous to Treasuries for US investor.  That option is their home country’s sovereign debt.  Some of the investments moving into Treasuries last year, and especially so far this year, moved from foreign countries’ sovereign debt.  However, those flows come from both equity and bond holdings in those foreign countries.  The correlation between stocks and bonds has broken down for those foreigners if funds flow out of all asset classes.

For the US investor, the potential for tail risk is currently concentrated in the international portion of their portfolio.  A previous posting entitled “Funds for AssetClass Diversification” discussed two mutual funds used to achieve international diversification.  The posting also discussed the philosophy behind holding those two funds.  They are treated similarly to any other position.  Thus, mutual funds are not the only way international diversification is achieved.  In addition to the funds there are individual stocks in non-US companies.  The potential of tail risk impacts each fund and individual stock holding differently.  Since this posting has so far discussed rebalancing in terms of asset classes, the balance of this posting will focus on the funds.  Individual stocks will be the subject of future posting.

The two funds in question are Spartan International Index Investor Class and the Lazard Emerging Market Equity Blend Portfolio.  The reader should keep in mind that it is not these particular funds that are at issue.  They were just chosen as representative of an asset class.  That is the role they played in the portfolio, and it is their role in this posting.  So, the issue becomes whether just having a representative of the asset class continues to make sense.

If the hypothesis that volatile foreign exchange rates and oil prices have increased the tail risk associated with foreign assets is correct, neither fund continues to provide the benefits that justifies including it in the portfolio.  In addition to the diversification benefits, the funds also embody a new higher probability of tail risk. An alternative strategy is to focus on specific stocks in non-US companies as a way to avoid the tail risk.  It should be possible to pick countries and companies that are less exposed to the potential of a collapse of the financial system of the country.

Since both funds include equities denominated in a variety of currencies, shifting to individual holdings could increase the currency risk as well as the company specific risk.  However, the tail risk seems to justify accepting the need to bear the foreign currency risk.  The currency risk was always there; picking individual holdings just makes it apparent.  The decision regarding how many non-US stocks and how many currencies have to be represented then becomes an issue of how confident the investor is in their ability to trade off tail risk against more concentrated currency and stock specific risk.