Raphael Stevens

“DIVERSIFICATION IS BOTH observed and sensible; a rule of behaviour which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim,” wrote Harry Markowitz, a prodigiously talented young economist, in the Journal of Finance in 1952. The paper, which helped him win the Nobel prize in 1990, laid the foundations for “modern portfolio theory”, a mathematical framework for choosing an optimal spread of assets.The theory posits that a rational investor should maximise his or her returns relative to the risk (the volatility in returns) they are taking. It follows, naturally, that assets with high and dependable returns should feature heavily in a sensible portfolio. But Mr Markowitz’s genius was in showing that diversification can reduce volatility without sacrificing returns. Diversification is the financial version of the idiom “the whole is greater than the sum of its parts.”An investor seeking high returns without volatility might not gravitate towards cryptocurrencies, like bitcoin, given that they often plunge and soar in value. (Indeed, while Buttonwood was penning this column, that is exactly what bitcoin did, falling 15% then bouncing back.) But the insight Mr Markowitz revealed was that it was not necessarily an asset’s own riskiness that is important to an investor, so much as the contribution it makes to the volatility of the overall portfolio—and that is primarily a question of the correlation between all of the assets within it. An investor holding two assets that are weakly correlated or uncorrelated can rest easier knowing that if one plunges in value the other might hold its ground.Consider the mix of assets a sensible investor might hold: geographically diverse stock indexes; bonds; a listed real-estate fund; and perhaps a precious metal, like gold. The assets that yield the juiciest returns—stocks and real estate—also tend to move in the same direction at the same time. The correlation between stocks and bonds is weak (around 0.2-0.3 over the past ten years), yielding the potential to diversify, but bonds have also tended to lag behind when it comes to returns. Investors can reduce volatility by adding bonds but they tend to lead to lower returns as well.This is where bitcoin has an edge. The cryptocurrency might be highly volatile, but during its short life it also has had high average returns. Importantly, it also tends to move independently of other assets: since 2018 the correlation between bitcoin and stocks of all geographies has been between 0.2-0.3. Over longer time horizons it is even weaker. Its correlation with real estate and bonds is similarly weak. This makes it an excellent potential source of diversification.This might explain its appeal to some big investors. Paul Tudor Jones, a hedge-fund manager, has said he aims to hold about 5% of his portfolio in bitcoin. This allocation looks sensible as part of a highly diversified portfolio. Across the four time periods during the past decade that Buttonwood randomly selected to test, an optimal portfolio contained a bitcoin allocation of 1-5%. This is not just because cryptocurrencies rocketed: even if one cherry-picks a particularly volatile couple of years for bitcoin, say January 2018 to December 2019 (when it fell steeply), a portfolio with a 1% allocation to bitcoin still displayed better risk-reward characteristics than one without it.Of course, not all calculations about which assets to choose are straightforward. Many investors seek not only to do well with their investments, but also to do good: bitcoin is not environmentally friendly. Moreover, to select a portfolio, an investor needs to amass relevant information about how the securities might behave. Expected returns and future volatility are usually gauged by observing how an asset has performed in the past. But this method has some obvious flaws. Past performance does not always indicate future returns. And the history of cryptocurrencies is short.Though Mr Markowitz laid out how investors should optimise asset choices, he wrote that “we have not considered the first stage: the formation of the relevant beliefs.” The return from investing in equities is a share of firms’ profits; from bonds the risk-free rate plus credit risk. It is not clear what drives bitcoin’s returns other than speculation. It would be reasonable to believe it might yield no returns in future. And many investors hold fierce philosophical beliefs about bitcoin—that it is either salvation or damnation. Neither side is likely to hold 1% of their assets in it.This article appeared in the Finance & economics section of the print edition under the headline “Just add crypto” More

IT IS ONCE again time for that most bizarre of economic spectacles, a debt-ceiling showdown in America. In the name of fiscal responsibility, the world’s biggest economy is flirting with an act of brazen irresponsibility: a sovereign default. The government has just about exhausted its current statutory debt limit of $28.5trn, after which it will struggle to honour its obligations. Janet Yellen, the treasury secretary, has warned that the government will probably run out of cash sometime next month.Most economists and executives assume that America will come to its senses before then. After all, Congress simply has to raise or suspend the debt limit, which it has done nearly 80 times since 1960, even if occasionally leaving it to the last minute. Should that occur again—and it almost certainly will—the debt ceiling will fade from view until the next clash, serving mainly as evidence of America’s polarised politics (as if any were needed).America’s ritualistic threats of economic self-harm are unique. But the debt ceiling is an extreme version of something that many other countries do: they limit government borrowing through fiscal rules. Germany applies a “debt brake”, capping its structural deficit at 0.35% of GDP (though it has ignored that cap since the outbreak of the covid-19 pandemic). In Britain the Conservative government aims to match its spending and revenues over a three-year horizon. Rishi Sunak, the chancellor, is expected to unveil even tighter rules in next month’s budget, including a commitment to lower the debt-to-GDP ratio.The purpose of fiscal rules is to deal with what economists call a “common pool” problem—namely, that beneficiaries of government spending ignore the costs imposed on taxpayers and future generations. The fear is that without a strict cap on spending, elected officials will burn through cash. Taken to an extreme, bond and currency markets might punish profligacy. Better not to test them. Hence the need, supposedly, for clear boundaries.Yet the past decade has shown that the boundaries are quite a bit wider and fuzzier than previously thought. In America federal debt was about one-third of GDP in 2000; today it is just about 100%. Far from precipitating a financial meltdown, the rising debt burden has become more, not less, manageable thanks to ultra-low interest rates. In nominal terms the cost of servicing all the debt (the annual interest payments on it) is just over 1% of GDP, nearly half what it was two decades ago. Similar trends have played out throughout the rich world. There may be no such thing as a free lunch, but governments have learned that they can get much larger portions for half the price.One response is to soften the limits. Take the European Union’s rule that member states must cap their debt at 60% of GDP—which is largely observed in the breach, with average EU debt levels now hurtling past 90% of GDP. Economists such as Zsolt Darvas of Bruegel, a think-tank, suggest that this limit should be treated as a long-term anchor rather than any kind of near-term target.Such a softening would help. But it would fail to deal with a more basic flaw with debt limits, which is that they are intrinsically arbitrary. There is little empirical basis for keeping debts to 60% of GDP, much less to exactly $28.5trn in America. The very arbitrariness of these red lines risks creating a boy-who-cried-debt syndrome. As borrowing levels blow past them and yet the economy continues to perform well, some politicians may conclude that any and all calls for fiscal restraint are best ignored.A more sophisticated response is to focus fiscal rules on what really matters about debt: the cost of servicing it. In a paper in 2020 Larry Summers and Jason Furman suggested that governments should aim to stop their real interest payments from rising above 2% of GDP. If they succeed, debt-to-GDP targets would be rendered all but superfluous. More generally, economists recognise that so long as a country’s pace of growth is higher than its interest rates, its path to fiscal sustainability ought to be easier, because its burden of existing debts will steadily shrink.However, these more elegant fiscal rules have their own problems. Why cap debt-servicing costs at 2% of GDP and not, say 3%. Moreover, the confidence that economic growth can surpass interest rates stems from the belief that rates will remain subdued well into the future as the population ages. But America’s ongoing bout of inflation has shown just how uncertain that is. Should central banks need to jack up interest rates to quell price pressures, debts would quickly spiral higher.You only give me your funny paperDoing away with indefensible lines in the sand altogether is a good alternative. In a paper this year Peter Orszag, Robert Rubin and Joseph Stiglitz argue for a new fiscal architecture. An important part would be to index long-term spending to underlying drivers. For example, social-security benefits could automatically be made less generous to take into account increasing life expectancy. This can be thought of as a fiscal rule that would commit governments to sensible budgetary decisions, rather than specifying debt targets with spurious precision.In another paper this year Olivier Blanchard and others proposed general fiscal standards for the EU, such as requiring governments to ensure that their debts are sustainable, but leaving it to them to choose their policy mixes. Independent fiscal councils could then use detailed debt-sustainability criteria to assess their budgets. If done methodically, this would be more scientific than the fiscal rules now seen in America and Europe.Alas, all these clever ideas may amount to nothing in America. There is little chance that the government will abandon its debt ceiling, for in one dimension it is most effective. Republicans have become dab hands at wielding it as a cudgel to stall the agendas of Democrat presidents and to portray them as spendthrifts. No other fiscal rules can deliver that kind of return. ■For more expert analysis of the biggest stories in economics, business and markets, sign up to Money Talks, our weekly newsletter.This article appeared in the Finance & economics section of the print edition under the headline “Rules of engagement” More

BERLINERS, MORE than four-fifths of whom rent their homes, have an unusual opportunity on September 26th to vent their anger over the rising cost of housing. A referendum, on the same day as Germany’s national and municipal elections, will give them a say on whether or not the city should in effect “expropriate” some of Germany’s largest residential-property firms, affecting up to 240,000 homes. The vote is non-binding. But its impact on the housing market is already having an effect. On September 17th two giant property investment trusts, Vonovia and a firm it is targeting in a €19.1bn ($22.5 billion) takeover, Deutsche Wohnen, said they would sell almost 15,000 flats to the city for €2.5bn. They portrayed it as a friendly gesture. But it was also a thinly veiled attempt to stop being stripped of the keys to their own homes.Whatever the outcome of the referendum, it serves as a warning for institutional investors piling into residential property in Europe and America. Real-estate investment trusts (REITs), private-equity firms, insurance companies and pension funds see the single-family rental housing market as a relatively high-yielding hedge against inflation that has been spared the impact of pandemic-related lockdowns on offices and shops. But housing affordability has high political sensitivity. In Berlin, rents have roughly doubled in a decade. Across Europe their rise has outpaced wage increases. In America, where a quarter of renters pay more than half of their income to landlords, rents in June were up 7.5% compared with last year, when they rose by 1.4%. The highest increases were in Phoenix and Las Vegas, up by 16.5% and 12.9%, respectively over the same time period. Nationally it is hard to lay the blame for the rent rises on institutional investors. But in some cities where they concentrate their portfolios, faceless megacorps are increasingly being seen as part of the problem.The biggest names are well known. BlackRock and JPMorgan Chase’s asset-management business feature among the stampede of buyers. KKR, a private-equity firm, is building out a new single-family landlord entity in America. The sums involved are rising fast. An estimated $87bn of institutional money went into America’s rental-home market during the first half of this year, according to Redfin, a residential brokerage. Around 16% of single-family homes for sale were bought by investors in the second quarter, up from more than 9% a year earlier. A similar shift is under way in Europe where firms such as Goldman Sachs, Aviva and Legal & General are wading into the market. Lloyds Banking Group, Britain’s largest mortgage lender, is also moving into housing with a target to purchase 50,000 homes within the next decade. That could make it the country’s largest landlord.It is not the first time the investment market has been hot. Blackstone, a financial conglomerate, was one of the first big investors to purchase foreclosed homes, many of them vacant or in disrepair, after the 2007-09 global financial crisis. The firm showed up at foreclosure auctions in America’s courthouses and drove street by street, comparing neighbourhoods and school districts. In 2012, it paid $100,000 for its first purchase in Phoenix. Soon it was spending $125m on homes each week. That same year Blackstone created Invitation Homes, now the largest owner of single-family rental houses in America, before taking it public in 2017 and selling off its shares two years later. Today Invitation Homes owns 80,000 homes out of a total market of 16.2m single-family rental homes. Altogether the bet on housing earned Blackstone nearly $7bn in dividends paid before and since Invitation Homes listed its shares, or more than twice its initial investment. The firm, which has returned to the market, recently made a $6bn acquisition of Home Partners of America, which owns more than 17,000 single-family homes. It gives its tenants the option to buy.The main impetus for the renewed investor enthusiasm is different from a decade ago. It is partly because of demography. Following the financial crisis, many millennials favoured metropolitan flats as they established their careers. As more of them enter middle age—the 35- to 44-year-old age cohort in America is expected to grow at double the pace of the average over the next five years—they want more space. It is also because of the pandemic. If remote working remains attractive, it will increase demand for homes that are farther from city centres. That helps explain why institutional buyers have piled into secondary cities such as Phoenix, Raleigh, Greensboro and Dayton.Many of this cohort would prefer to buy than to rent, but high house prices are an impediment. In America, the median home cost around 4.3 times the median household income in 2019, up from 3.9 times in 2002. In Britain the average home currently costs more than eight times average earnings—a level that has only been breached twice in the past 120 years. Even if rents are rising, too, leasing a suburban home with an office and room to raise children can be an interim option.Some people blame large investors for both skyrocketing house prices and rising rents. At an aggregate level that’s a hard case to make. Professional investors own just 2% of the total rental-housing stock in America. In Europe, less than 5% of residential real estate is in the hands of large, publicly traded funds. But in those cities where institutional investors are increasingly active, they may have more of an impact. They also frequently pay with cash, giving them an edge over buyers with a mortgage in a competitive market. One in six home sales in America went to an investor between April and June, according to Redfin. In cities such as Atlanta, Miami and Phoenix, the figure was one in four.That may explain some of the political scrutiny. “Institutional investors are walking on a tightrope,” says Cedrik Lachance of Green Street, a property-analysis firm. On the one hand, rising rents make investments more attractive. On the other hand, they invite tougher policy responses. The White House is placing limits on the sale of lower cost homes to large investors. In Ireland, property taxes were raised to stop institutional investors from snapping up family homes that would normally be marketed to first-time buyers.Such regulatory responses may be crowd pleasers. They will not solve the rental problem. One study showed that rent-control policies in Catalonia, a region of Spain, not only failed to make the market more affordable, but actually worked against it. The number of homes available fell by 12% while prices remained unchanged. Similarly, researchers studying the impact of a five-year rent freeze in Berlin found that the number of rental properties slumped last year. Catalonia’s law has been challenged by a constitutional court. Berlin’s has been struck down.Instead, more homebuilding is the answer. Some landlords argue that they increase the housing stock by offering developers the certainty of bulk purchases. Lennar, America’s largest home builder by revenue, recently signed a $4bn deal with investors that includes building over 3,000 homes. Additionally, REITs in America such as Invitation Homes and American Homes 4 Rent are either building more homes or striking partnerships with homebuilders to boost their supply. In Britain, where one in five newly built homes could be institutionally-owned by the end of the decade, Lloyds has announced a fund to boost house building in return for a share of the profit. Professional landlords that own multiple properties also claim that they’re able to offer better services, more maintenance and longer leases than individual landlords who could sell up at any moment.But in the wake of the pandemic, homebuilding globally is anaemic. Shortages of labour and material have stalled growth. Fewer homes coming onto the market meant that single-family institutional investors in America increased their portfolios by 1.5% in 2020, down from 9.2% in 2018, according to Amherst Capital, a property firm. Less homebuilding increases the chance that rents will continue to rise. Annual returns in America and Europe are expected to be as high as 15.1% and 17.5% respectively over the next few years. The asset class will therefore remain enticing from an income standpoint, but more risky from a regulatory one. Even if a majority of Berlin’s renters vote against the landlords, it’s hard to imagine meaningful law changes to curb property rights. But for the greediest investors, the writing is on the wall, four windows and a door. ■This article appeared in the Finance & economics section of the print edition under the headline “The new rent-seekers” More

Check out the companies making headlines before the bell:
Darden Restaurants (DRI) — The Olive Garden parent reported earnings of $1.76 per share, higher than the $1.64-per-share forecast. The restaurant company also reported same-store sales that rose 47.5%, topping estimates. Shares rose 3% in premarket trading.

BlackBerry (BB) — The company reported better-than-expected quarterly earnings, with an adjusted gross margin of 65%. BlackBerry reported a loss of 6 cents per share, compared with the expected loss of 7 cents per share, according to Refinitiv. Revenue came in at $175 million, topping estimates of $164 million. Shares rose more than 7% premarket.
Salesforce (CRM) — The software company raised its full-year 2022 revenue guidance to between $26.25 billion and $26.35 billion. This is higher than the company’s previous estimate of revenue between $26.2 billion and $26.3 billion. Analysts expected $26.31 billion. Shares rose 2% in premarket trading.
KB Home (KBH) — Shares of the homebuilder rose in premarket trading despite missing top and bottom-line estimates. KB Home reported quarterly earnings of $1.60 on revenue of $1.47 billion. Wall Street expected earnings of $1.62 per share on revenue of $1.57 billion, according to Refinitiv.
Joby Aviation (JOBY) — Morgan Stanley initiated coverage of the air taxi start-up with an overweight rating, saying in a note to clients on Thursday that investors should take a look at a stock with major potential upside. Shares of Joby Aviation popped more than 5% in extended trading.
Biogen (BIIB) — The drugmaker’s stock rose in premarket trading after Needham initiated coverage of the stock with a buy rating, saying in a note to clients on Wednesday that the company’s controversial Alzheimer’s drug Aduhelm will be a big seller for the company long term.

Roku (ROKU) — Shares of the streaming company rose 2% in premarket trading after Guggenheim upgraded the stocks to buy from neutral. The Wall Street firm assigned Roku a 12-month price target of $395, implying a 22% one-year return.
SoFi (SOFI) — Shares of the fintech company rose in premarket trading after gaining 11% during the regular session on Wednesday. Sofi is the 6th most-mentioned stock on Reddit’s WallStreetBets, according to quiver quant.
Accenture (ACN) — Accenture shares rose in extended trading after reporting better-than-expected earnings. The company also increased its dividend and buyback authorization.

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