Focus on Fixed Income

In the last Live Market Update for our clients, we talked about the importance of the bond market in predicting economic conditions.  For all the talk about how the stock market is a perfect aggregation of information across all market participants (i.e. people), it actually does a pretty crummy job of predicting future economic troubles.  In fact, equities lag behind economic decline in most cases.  For instance, the Great Recession was well under way by the time the stock market corrected and collapsed nearly a year later.   Keep in mind that it takes months to a year to collect enough data to determine the actual start of an economic decline.

While academics and theorists claim the market is “efficient,” the opposite is often true.   Equities appear to move almost entirely on expectations formed from the last 30 days of market experience, with news “shocks” randomly bumping it off that trajectory. This can be seen today in the fear gauge, or the VIX.  As markets climb the fear gauge creeps lower and lower to reach historical levels when the markets are doing fine.  Yet as soon as something comes along to disrupt expectations, such as the yuan devaluation last August, the VIX soars to levels indicative of a massive economic collapse—reactively, not proactively.

That leads me to a discussion of bonds.  Also called fixed income, this market is many times larger than the stock market and encompasses a wide range of instruments from mortgages to auto loans.  It is also a space retail investors have eschewed for the past five years.  Back in 1994 when I interned on the floor of the New York Stock Exchange, I already noticed an interesting contrast between people working in equity markets versus those working in fixed income. Those working in the equity markets were typically guys of moderate education with strong sports backgrounds. Those in fixed income were a more diverse bunch of quants, often with advanced degrees in physics, mathematics and economics.

While the nature of equity trading has evolved since that time, it is still true that the fixed income arena requires a more nuanced understanding of mathematics and economics.  For reasons that likely are related to these factors, the bond market is a remarkably good indicator of future conditions.  Figures 1 and 2 show this in both the Dot-Com burst and the Great Recession.  In both cases, the difference in yield between 2-year treasury notes and 30-year treasury bonds moved to zero.  The positive yield difference in these two instruments is usually a reflection of expectations of future inflation.  In both instances, this bond market metric correctly predicted that future inflation disappear as the economy went into a severe contraction.

While nothing is perfect in any market, the analysis of the bond market is typically a good indicator of what is to come, at least at its extremes.  Today we sit at an odd point with those indicators.  The 10-year U.S. treasury rate is at its lowest point ever (see Figure 3).  Comparative rates in Germany, Switzerland and Japan are all negative—meaning investors will get less than their principal back when they buy a 10-year bond from those governments.  And looking here at the U.S. yield curve (Figures 1-2), the 30 minus 2-year rate is declining slowly but steadily.

So while neither of these indicators is a clear signal of trouble ahead, the trends undermine the prospect of strong economic conditions inferred by the equity market rally.  Going forward, these conditions start to make a strong case for depressed equity returns in the next few years with modest gains in the bond market.  In other words, play for a relatively safe investment strategy with less reliance on equities coupled with modest expectations for returns in the next few years.

 

Regards,

sig

David B. Matias

Managing Principal

 

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Brexit Explained: 99 Problems but No Solution in Sight

To our readers,

Until now I have had the pleasure of writing the majority of our blog entries, but am very happy to now present the writings of Juliana Cusack.  Juliana is our analyst on the venture fund and works closely with investment team on economic matters.  While I will continue to write the quarterly Market Updates and some Market Notes, Juliana will now be a regular contributor to this space.

Her first piece on Brexit is below.  It will help to clarify some of the bigger issues was are facing as we head into the summer months.

Thanks,

David

 

On June 23rd, Britain will vote on whether to ‘Remain’ or ‘Leave’ the European Union (EU) in a move that has significant implications on the US’ biggest ally and the broader European community. The sentiment underpinning this vote is strong and frustrated. The vote itself was a concessionary promise made by David Cameron to a swath of reluctant supporters during his last campaign. While it seemed unlikely to materialize, thirteen days to go and the ‘Leave’ camp is leading by a percentage point in the polls, with 12% still undecided.

The ground-swelling of anti-European sentiment is in large part due to the expansion of the EU in geography and scope, as well as the emergent and fragmented terrorist threat. But like the Trump factor here in the US, the impact of globalization and displacement of blue collar jobs has exacerbated these issues and laid the foundation for xenophobic and isolationist attitudes to take hold. A discussion of each of these factors follows below.

Trade 

Trade is arguably the most important aspect of the European ‘project’, with the European Union initially established as a duty-free trade alliance. The EU currently absorbs 44% of British exports, linked to 3.3 million British jobs. The severity of the impact is, of course, debated and subject to post-exit negotiation, but if the UK left, trade would likely be governed by the WTO, where members can impose tariffs on imports that average 9% when no preferential deal is in place. The relative increase would almost certainly hurt both UK exports and consumers.

Moreover, firms located in London are currently granted a ‘passport’ allowing them to operate in other EU countries without undergoing separate regulatory oversight. This has implications particularly for London’s substantial financial services sector, which currently benefits from being able to clear transactions denominated in euros, a function not possible after an exit. While more limited free trade deals have been negotiated, as with Switzerland, Canada, and Norway, they are unlikely to be lenient in negotiations given the signaling towards the already weakening European unity and the competitive position of the UK’s financial sector.

No one, except European capitals eager to fill the void if London were to exit the Common Market, is arguing the trade benefits that come from membership. If anything, ‘Leave’ supporters are most frustrated with the EU’s evolution beyond a trade alliance, but are still confident that loss of trade will be made up for by trade with China, India, and the US.

Immigration

‘Leave’ supporters are certainly fired up about the EU limiting Britain’s ability to control the number of immigrants reaching their shores, a fact blamed for decreasing wages and an overheated real estate market. Part of this is due to the unprecedented enlargement of the EU. When free movement to the UK for citizens of new EU members was first agreed to in 2004, 100,000 migrants were expected in the first decade after enlargement. In the end, it was 1.4 million, roughly half from the original member states and half from the poorer new members of Eastern Europe. Eastern European arrivals are more likely than previous migrants to settle in small towns, presenting challenges for local authorities. And in fact, the loudest voices in the ‘Leave’ camp come from outside of the capital.

Terrorism

The issue of terrorism is delicately intertwined in immigration issues, particularly given the disparate and concealed threat posed by ISIS. Many people believe terrorists can slip in undetected with streams of migrants, only made worse by the imagery provided by the attacks in Paris and Brussels.

Consider the fact that Ibrahim El Bakroui, an organizer of the Brussels attack was put on a watch list in Istanbul after being arrested near the Syrian border, but no information was provided to Belgium authorities after he was sent back. Cooperation between France and Belgium would also have been prudent as attackers, originally planning to target France, easily shifted their plans to Brussels given their freedom of movement. Local police in Molenbeek, Belgium, also failed to pass on key information regarding the hiding place of the last remaining Paris attacker for three months.

Figure 1: A map indicating EU and Schengen membership across Europe highlights the issue of terrorism prevention when information is not shared between countries with open borders. source: ec.europa.eu

Europe faces unique challenges in preventing terrorism given their porous boundaries, bureaucratic complexities, and inclusion of former-Soviet territories. While the UK is not a member of the Schengen Zone, this prevents the tracking of dangerous persons and strengthens terror networks across borders. Each EU member, including those with freedom of movement, has different legal frameworks and rules on the classification of secrets. Europol has been at the heart of intelligence-sharing initiatives, but the authority has no ability to make arrests and has been slow to garner buy-in from its members.

Political 

The issues around trade, immigration and terrorism are all significant. But some also say that moreover, this is a struggle over identity. The UK is separated from the rest of Europe by language, geography, and culture. As the NYTimes put it, “In [the pro-Brexit] view, the country is being overrun by foreigners who not only take their jobs and welfare benefits, but also bring fundamentally different values into Britain.”

The European Union offers the UK a platform to spread its values and participate among its allies in the fight for human rights and safety in difficult times. This participation offers significant benefits.  But the cost of that is a loss of sovereignty to European officials, unelected by the UK populace but whose laws make up 15% of the UK’s total. People also focus on the UK’s contribution to the EU budget, which totaled 13 billion GBP in 2015.

article-2180177-143FE071000005DC-507_634x426Image 2: An image from the Opening Ceremony of the London Olympics in 2012 celebrated an eccentric image of British culture throughout the decades. 

Your Portfolio

Since polls showed a tip towards the ‘Leave’ camp earlier this week, the FTSE 100 Index (UKX) fell -3.49%, the Euro Stoxx Pr Index (SX5E) fell -4.58% and the S&P 500 fell -1.12%. Global fund managers’ allocation to UK equities are at the lowest levels since 2008 and the pound fell against all 16 major peers. Nevertheless, many say markets are still not prepared for a ‘Leave’ vote, and there would certainly be further fallout for global markets, and the UK and Europe in particular.

There is not much European exposure in the portfolios though there is a small amount of the Vanguard FTSE Europe ETF (VGK), which was added in July 2015. The ETF had a low in February but has been crawling back since. We have also had a rocky time with Santander (SAN), which has been subject to the European instability as well as internal challenges brought on by new leadership. Nevertheless, volatility is dangerous and market events are all felt across borders, including here in the US.

Our Small Account Toolbox

We hear it all the time.  It’s usually spoken in a lowered tone as if it may be found offensive: “I don’t know if their account is big enough for you.”  Clients, friends, and acquaintances are often fearful that the people they refer to us won’t have enough money to invest, and therefore won’t get enough of our attention.  Let us put this trepidation to rest: the people you refer to us are important to you, which instantly means they’re important to us.

Clients with smaller accounts face the same, or even greater challenges in planning for their financial future, and we have a number of tools to help them do this.

Say a client refers their niece to us who is just starting out in her professional career and is interested in buying a condo in the next five years.  In this case, we’d sit down with her, either in person, by phone, or on Skype, and build a basic financial road map using MoneyGuidPro, the same financial planning software we use for our multi-million dollar families.  One of the most powerful tools for a young account is to set up automatic contributions to her investment account and time it so that the money is deducted from her bank on the same day she gets paid.  That money then can be invested based on the financial road map that we constructed together.

While individual stock or bond selection is a good technique for fund management, the size of the trades relative to the clearing charges by the custodian bank would erode returns. TD Ameritrade does, however, offer 100 Exchange Traded Funds, or ETFs, that we can use commission-free. Once the money is invested, we rebalance the account every three months to make sure the percentages are back on track and in sync with her financial plan. TD Ameritrade offers a robust rebalancing tool that lets us take into consideration things such as tax consequences and future cash needs.

She’ll want to keep track of her savings progress and investment performance, and she can easily do this by logging into Orion; again, the same portfolio reporting software our multi-million dollar families use to view their accounts.  This will give her the quick snapshot she needs until we check in with her in 6 to 12 months to review the account in detail.

This process helps this young woman identify her goals, and lays out the steps to be taken to meet them, a great first step for a young account. Creating a financial plan, setting automatic contributions, rebalancing at regular intervals, and managing risk, especially when done early on, can ensure that you are well prepared to meet your financial goals, whether they include a house, a child, or retirement.

Mitigating interest rate risk through bond ‘ladders’

There’s been a lot of talk lately about the inevitable rise in interest rates, including particular concern on behalf of bond investors.  While there is consensus that rates will rise, no one is sure when. The US is still recovering from the great recession, economic growth is slow, and median household income has declined. It is conceivable that interest rates could remain low for quite some time.  Taking the Fed announcements at face value, interest rates will rise when economic conditions in the US warrant it.

The concern of bondholders is valid, as the value of bonds will indeed decrease when rates go up.  If rates are up, your market price will be lower and vice versa if rates go down.  As a result, investors can see wide fluctuations in value depending on maturity dates, and this can be unsettling.

The good news is bonds that pay a fixed coupon (some have a variable coupon) will pay a steady stream of income regardless of interest rate movement.  Since the coupon is fixed, the income from the bond will remain unchanged – no matter what the current price is.  Thankfully, we are able to structure the bonds within the portfolio such that the impact of interest rate movement is minimized, even when we do not know when interest rates will rise.  An effective method for mitigating interest rate risk is to create a bond “ladder”.  This is a strategy that has one or more bonds come due over a period of years.  For example, if you had $100,000, you would have a $10,000 bond come due once a year for ten years.  If your ladder is established before a rise in interest rates, you will be getting cash from maturing bonds to re-invest at higher rates as they come due.

Building an effective ladder starts with defining your objectives, structuring the capital allocation within the portfolio, and not concerning yourself with the timing of purchases.

Curing Hepatitis

Hepatitis C virus, artwork

HCV Cell © Mehau Kulyk/Science Photo Library/Corbis


Hepatitis C Virus (HCV)

There has been much discussion and news lately about a new breakthrough in therapy for people with hepatitis C (HCV).   This is a relatively recent development and its ramifications represent a major breakthrough for human health as well as a significant investment opportunity.

First identified in the early 1980s, HCV is a small (55 – 65 nm) single-stranded RNA virus that causes inflammation of the liver in humans. It is contracted through blood exchange from blood transfusions, needle sharing (IV drug use), and tattoos and is considered the most serious of hepatitis viruses. The virus primarily uses hepatocytes (liver cells) for replication. HCV causes cirrhosis (scarring) and if left untreated, hepatic carcinoma and eventual death. It has also been established that it uses elements of the central nervous system for replication as well. Neurological manifestations of untreated HCV involve autoimmune disorders such as Sjogren’s syndrome, cryoglobulinemia, general neuropathies and cognitive impairment, to name just a few.

Vodia Mandate

As the world population continues to grow and pressure on global resources, public health and economic stability mounts we look for investment opportunities that address our biggest challenges and span multiple disciplines. Part of our mandate is to seek value that is created from companies that build sustainable business models in health, technology, timber, housing, food and water to solve some of our most pressing problems. The development of antiviral therapies for treatment of hepatitis C is of particular interest because of its vast potential for improving human health – and consequently, its commensurately large market potential. In addition, some of our brightest scientists and best companies are investing large amounts of human, intellectual, and monetary capital towards combating viruses. Companies like Johnson & Johnson, Merck, AbbVie and Bristol-Meyers Squibb are dedicated to creating cures and are making progress in the development of antiviral medications for hepatitis.

HCV: U.S. and Worldwide

  • Estimated number of people in the US with chronic HCV: 2.7 to 3.9 million [1]
  • Estimated number of people worldwide to have chronic HCV: 170 to 200 million [2]

(These estimates exclude the homeless and the prison population. It is estimated that 1 in 3 incarcerated individuals in the US are HCV positive.)[3]

  • Estimated number of recorded deaths each year from HCV-related liver disease: 350,000 – 500,000 [4]
  • Tattoos are now a leading cause in the spread of HCV. [5]

(These estimates are likely to be very low because people with chronic HCV can live for decades without any symptoms and therefore never know they have it.)

 

Table1 6.23.14

 

 

 

 

*Actual acute cases estimated to be 13.4 times the number of reported cases in any year. [6]

Gilead Sciences

Until very recently, people with hepatitis C were faced with the prospect of living with and managing the disease because there was a low probability of a cure and the treatments that were available caused serious medical problems. There were very few – if any – good options. This is no longer the case since Gilead Sciences has come to market with a cure.

Gilead Sciences (GILD) is a research-based biopharmaceutical company that discovers, develops and commercializes innovative medicines in areas of unmet medical need. GILD has an impressive portfolio of antiviral therapies that address HIV/AIDS, liver diseases, respiratory and cardiovascular conditions, cancer and inflammation. They have achieved a number of “firsts”: most notably, they were first to market with a complete treatment regimen for HIV infection available in a once-daily single pill. The bulk of GILD’s revenues come from its market-leading HIV franchise of therapies, Atripula and Truvada. Gilead has now expanded to antiviral therapies for hepatitis and achieved another first on December 6, 2014 when they received FDA approval for their new HCV antiviral, Sofosbuvir. Sofosbuvir is a polymerase inhibitor. In simple terms, the drug finds the protein (NS5b) that is responsible for viral RNA replication and blocks it. The result is the termination of the replication process, which leads to cure. The brand name of the drug is Sovaldi and the administration of therapy lasts from 12 to 24 weeks. Taken in combination with Ribavirin, Solvaldi has demonstrated a >90% cure rate in HCV genotypes 1, 2 and 3. [7] Solvadi may be the most successful and fastest drug launch on record.

The launch of Sovaldi propelled Gilead’s earnings to one billion dollars over analysts’ estimates in the first quarter of 2014. The following chart shows the increase in all antiviral sales from Q1 2013 to Q1 2014.

Table2 6.23.14

Price Wars and Protest

Sovaldi’s price tag for 12 weeks of therapy is $84,000. Despite protests from pharmacy benefit managers, such as Express Scripts, insurance companies are approving and paying for it. Express Scripts threatened to start a price war between Gilead and upcoming competitors such as AbbVie, J&J and Merck. Gilead’s competitors, who have also made substantial investments into HCV antiviral therapies, have suggested that they are not interested in a price war. Even the US Senate has joined the discussion and held hearings in March 2014 asking Gilead to explain Solvaldi pricing. The cost of any treatment regimen, however, must be evaluated in the context of probable outcomes and the costs associated with them. While the price may seem high, Sovaldi was priced so that the total cost of treatment is comparable to the prior regimen protocols. Prior treatment protocols were to engage in a 48 – 52 week regimen of a combination therapy of Peginterferon and Ribavirin. The side effects of this therapy are so severe that patients often delay starting treatment or are forced to terminate prematurely. Additionally, the efficacy across HCV genotypes (GT) 1, 2 and 3 of the Peginterferon/Ribavirin treatment is mixed and falls short of the Gilead regimens by wide margins.

Peginterferon/Ribavirin                                                    Sovaldi/Ribavirin

GT 1: 31%-54% sustained viral response (SVR)         >90% cure rate in HCV genotypes 1, 2 and 3 [10]
GT 2-3: 64-80% SVR [9]

Failure of treatment leads to other very costly medical problems such as cirrhosis, cancer and liver transplantation. When evaluated in this context, Sovaldi is less expensive than prior regimens.

Valuation

Gilead offers guidance for 2014 sales of all of its products at a range of $11.3 to $11.5 billion. Importantly, Sovaldi sales are not included in Gilead’s 2014 guidance. Meeting these estimates (excluding Sovaldi sales) would bring Gilead’s price-to-earnings (P/E) ratio from 29.5 down to 13. Considering the industry P/E average of 69, this suggests the company is undervalued relative to its peers. Sovaldi sales were $2.3 billion in the first quarter of 2014 and the consensus view is that Gilead’s HCV therapy sales could reach $12 billion in 2015[11]. Even if the consensus is wrong, three million Americans have Hepatitiis C. It would cost $250 billion to provide treatment to them all.   Add in the WHO’s estimate of 170 million with HCV, and it’s clear the market is extremely large.

Risks

Increasing competition from Bristol-Meyers Squibb, J&J, AbbVie, and Merck (by acquisition) along with pricing pressure from payors such as governments in Europe and pharmacy benefits managers in the U.S. are risks for Gilead. Austerity measures in Europe as well as increasing health care costs in the US will continue to exert downward pressure on pricing.

We believe Gilead’s leverage lies in the unprecedented safety and efficacy of Sovaldi and that they are significantly ahead of their competition in terms of timing. We also believe that since there is no longer a reason to delay or avoid treatment the market is very likely to reveal itself to be much larger than currently understood (consider the prevalence of tattoos). This would likely absorb any future reduction in price if Gilead were forced to negotiate. In addition, Medicare recently decided to cover screening costs for hepatitis C. This will facilitate Medicare payment for hepatitis C treatment. [12] Finally, the diversification and strength of Gilead’s total antiviral portfolio forms a solid foundation for potential growth.

What’s Next?

The next advancement of Gilead’s HCV treatment is finishing phase three clinical trials. This is a single-dose combination therapy of Ledipasvir and Sofosbuvir. While Sofosbuvir blocks NS5B, the non-structural protein essential for replication, Ledipasvir blocks NS5A, a protein that plays a more complex role in the life cycle of a HCV viral cell but is also important to the replication process. The combination of Sofosbuvir and Ledipsavir could represent the final eradication of HCV across all genotypes.

Lead by CEO John Martin, PhD and COO John Milligan, PhD the management team has demonstrated exemplary stewardship of the company. Gilead’s concentration on infectious diseases, relatively low overhead, continued development of next generation therapies and strong intellectual property portfolio have helped Gilead establish the dominant position in the marketplace.

Disclosure:  Vodia Capital has established a long position in GILD for some clients.


© Dwight Davenport 2014
Dwight Davenport may be contacted at ddavenport@vodiacapital.com

 

Endnotes

[1] Center for Disease Control and Prevention (CDC). Viral Hepatitis statistics and surveillance, accessed May, 2014 at http://www.cdc.gov/HEPATITIS/Statistics/index.htm

[2] World Health Organization (WHO), Hepatitis C fact sheet, accessed May, 2014 at http://www.who.int/mediacentre/factsheets/fs164/en/

[3] – CDC publication # 21-1306, HepCIncarcerationFactSheet-BW.pdf

[4] Personal interviews of gastroenterologists and hematologists

[5] World Health Organization (WHO), Hepatitis C fact sheet, accessed May, 2014 at http://www.who.int/mediacentre/factsheets/fs164/en/

[6] CDC, http://www.cdc.gov/hepatitis/Statistics/index.htm accessed May, 2014

[7] US Government, www.Clinicaltrials.gov accessed June, 2014. See also Gilead Sciences, Sovaldi prescription information fact sheet http://www.gilead.com/~/media/Files/pdfs/medicines/liver-disease/sovaldi/sovaldi_pi.pdf

[8] Gilead Sciences, http://investors.gilead.com/phoenix.zhtml?c=69964&p=irol-newsArticle&ID=1920785&highlight, accessed June, 2014

[9] The Alfred 2002. www.hivhepsti.info accessed June, 2014, fact sheet Ribavirin/Pegylated Interferon Combination Therapy for People with HCV

[10] US Government, www.Clinicaltrials.gov accessed June, 2014. See also Gilead Sciences, Sovaldi prescription information fact sheet http://www.gilead.com/~/media/Files/pdfs/medicines/liver-disease/sovaldi/sovaldi_pi.pdf

[11] Morniingstar.com, accessed June, 2014

[12] Centers for Medicare and Medicaid services, http://www.cms.gov/medicare-coverage-database/details/nca-decision-memo.aspx?NCAId=272, accessed June, 2014

Efficacy of treatment using Sovaldi (sofosbuvir)

Response Rates in Study POSITRON*

GT 1: > 90% SVR

GT 2 & 3: 61 – 93% SVR

(www.Clinicaltrials.gov – See also Fact sheet on Solvadi, www.gilead.com)

*POSITRON was a randomized, double-blinded, placebo-controlled trial that evaluated 12 weeks of treatment with SOVALDI and ribavirin (N=207) compared to placebo (N=71) in subjects who are interferon intolerant, ineligible or unwilling. Subjects were randomized in 3:1 ratio and stratified by cirrhosis (presence vs. absence). Treated subjects (N=278) had a median age of 54 years (range: 21 to 75); 54% of the subjects were male; 91% were White, 5% were Black; 11% were Hispanic or Latino; mean body mass index was 28 kg/m2(range: 18 to 53 kg/m2); 70% had baseline HCV RNA levels greater than 6 log10 IU per mL; 16% had cirrhosis; 49% had HCV genotype 3. The proportions of subjects who were interferon intolerant, ineligible, or unwilling were 9%, 44%, and 47%, respectively. Most subjects had no prior HCV treatment (81%). Table 12 presents the response rates for the treatment groups of SOVALDI + Ribavirin and placebo.

 

Research Note, Thailand – June 4, 2014

You have possibly heard about the military coup that occurred in Thailand on May 22, 2014. In brief, the military imposed martial law and has dissolved much of the elected government. They are establishing a new economic plan, and have temporarily installed the head of the military as the prime minister. In short, democracy in one of the world’s strongest economies is now dead.

Like most news events, this is a story that requires a far deeper understanding to appreciate all of the ramifications. While an objective assessment would be prudent, I am clearly biased by my connections and friendships in the country. What I see is a logical progression that started many years ago with the dismantling of their democracy when Thaksin Shinawatra’s political party (Thai Rak Thai) was elected into power – the man whom this is all about.

A quick history of recent developments in Thai politics begins with Thaksin, a former policeman-turned business leader who was elected prime minister in 2001 through the support of the mostly rural and poor farmers of Thailand. Thaksin did some good for the country in the form of rural development programs. But the downside was corruption – he is a deeply corrupt politician who used his control of the elected bodies to neuter the country’s enforcement agencies and anti-corruption safeguards. In the end, he fled Thailand for Dubai with billions in illegal wealth, escaping a two-year prison term.

In the next act of this drama his sister, Yingluck Shinawatra, who was elected prime minister in his wake on essentially the same platform as her brother, brought further economic revival to the countryside. Her method was far cruder than her brother’s. She promised and delivered on artificial price supports for rice farmers by raising the price that the Thai government would pay per ton of rice. The effect was devastating for the government. Farmers benefitted, but the government incurred at least $4.4 billion in losses (WSJ, June 17, 2013) as the rice they bought rotted in warehouses while rice prices continued to decline due to global overproduction.

This might all have been put under the rubric of bad economic policy if it were not for her last significant move as prime minister – to propose amnesty for her brother to return to Thailand and Bangkok politics. It was this last straw that led to protests, riots, and various forms of political maneuvering, rendering the current government ineffective with no clear path for bringing in a newly elected government.

While it is still not clear what precisely triggered the military’s move at this point in the drama, it is not unexpected. Thailand has a long history of military coups, the vast majority of which are without violence or bloodshed. The military is loyal to the King and only acts when there is a significant threat to the royalist nature of the country. If things go as hoped, the military rule will eventually give way to a political body that is largely in line with the King and a pro-economic ruling party. The issues of corruption still exist, and it will be quite some time until truly elected bodies will be able to function as a democracy, but this is a positive step forward.

From an investor’s perspective, this is welcome news. The market value of our holding, an ETF based on the Thai SET 50 Index (THD), moved in a narrow range immediately following the coup and is now up 4%. The larger volatility in the related index occurred many months ago when uncertainty around the Yingluck government arose and the prospect of Thaksin’s return was real. That was when we first entered the position – after a 20% drop in the Thai index on the fears of a political upheaval.

 

Chart 1 – The Thai SET 50 has suffered tremendous volatility in the past year as the political situation deteriorated in the country. The Amnesty Bill, allowing Thaksin to return, was the trigger that eventually led to the current coup. The market abhorred the Amnesty Bill, yet welcomed the coup.

Chart 1 – The Thai SET 50 has suffered tremendous volatility in the past year as the political situation deteriorated in the country. The Amnesty Bill, allowing Thaksin to return, was the trigger that eventually led to the current coup. The market abhorred the Amnesty Bill, yet welcomed the coup.

 

Our focus now will be on how the military stabilizes the economy and sets a path for the transition to an elected government. The real damage has already occurred – Thailand’s economy contracted last quarter due to the turmoil and poor economic policies during Yingluck’s tenure. Nicknamed the “Teflon economy,” Thailand has one of the most resilient economies in the region, capable of strong growth based in Southeast Asia’s global expansion. With the elected government’s dysfunction out of the way, the country can return to stable growth as the civil administrators, business leaders and foreign investors are again able to return to the business of doing business.

All the best for an enjoyable summer.

David B. Matias, CPA

Managing Principal