Turbulence in Financial Markets - admit to your biases
David Miller - 15.1.08
Two books written in the 1960s may be of some help in understanding what is driving financial markets at present.
It is over forty years since the publication of the Money Game by fund manager turned journalist George Goodman, writing under the pseudonym of Adam Smith. I make a point of reading this classic book about how financial markets really work at some stage during each market cycle, usually at times of stress. Now seems as good a time as any to see whether what moved markets in 1967 remains pertinent.
US Equities Long Term Performance
Source: Bloomberg
Volatility
Source: Bloomberg
One chapter is entitled ‘Mr Smith admits his biases’. Trying to make sense of what has gone on in recent months, and make some judgement on how to proceed requires not only a careful assessment of the facts but also a judgement about the psychological state or biases of investors and central bankers.
Successful long term investment is about managing risk, diversification and taking advantage of opportunities as they occur. Astute risk management is as much about knowing when to take increased risk as when to reduce it. Diversification has to be genuine rather than cosmetic and even long term investors have to be prepared to make quick decisions during volatile market conditions.
The removal of trade and financial barriers over the last quarter of a century has made markets far more correlated than in the past. However, one of the interesting issues that has emerged is that investor attitudes vary from country to country and so does the approach of central bankers. In the current environment both groups have a very important role in re-establishing stability. In the UK investors are committed to international diversification, because of the limitations of the UK economy. Furthermore, although inflation has been low for many years, we remain scarred by our inflationary experience in the 1970s. Property and equities proved to be a better store of value during this difficult time than bonds. In contrast, continental European investors are more interested in liquidity and security. Their inflation experience has been better over the last 30 years, hence their rather different attitude. Moving further afield, Latin American investors have an entirely different bias. All have very clear memories of currency devaluation, high inflation and government default. The concept of cash on deposit at the bank and sovereign debt as risk free is rather alien and as a result, absolute return strategies such as hedge funds were adopted as a core part of investment portfolios much earlier than in Europe.
Central banks have their own set of biases and again these differ by region. In Europe, controlling inflation remains the top priority not only in Germany but in other countries with less satisfactory records of financial control. In contrast the Federal Reserve believes that poor monetary policy turned a recession into the 1930s depression and has no wish to repeat the mistakes of the past. Looking back to 2000-2003, it is no surprise that it was the Federal Reserve that was prepared to cut interest rates to 1% in order to sustain economic growth rather than the ECB.
A good measure of uncertainty is volatility and perhaps the best known is the Chicago Board of Options Exchange Volatility Index usually referred to as the VIX, which is a weighted average of option implied volatility.
The first conclusion to draw is that risk is now more appropriately priced. Therefore, investors taking 12-18 months need to be looking for opportunities to put money back into risk assets on a diversified basis. There are many more opportunities now than six months ago.
At the beginning of 2007, central banks including the all powerful Fed were thought to be passengers rather than drivers of growth. Now what Fed officials choose to say and do has become extremely important. The provision of liquidity by central banks has ensured that financial markets have continued to operate in an effective manner, but we are at a critical stage in the economic cycle. The key decision will be whether to stimulate economic growth, which is slowing, by cutting interest rates or to make entirely certain that inflation, which tends to be a lagging indicator, is well and truly under control. True to form the Fed is cutting interest rates to stimulate growth whilst the ECB is providing huge amounts of liquidity to the banking system to maintain stability, but is not, as yet, prepared to follow the Fed lead on rates.
In 1962, Anthony Sampson wrote ‘Anatomy of Britain’, in which he explained how our various institutions control the levers of power. He also ranked them in order of importance. Over the next forty years, he returned to this subject on a regular basis and, just prior to his death in 2004, updated his views in ‘Who Runs This Place’. Of particular interest was how the rankings had changed. The top performer has been the media.
The same exercise for UK financial markets would yield similar results. At various times, leadership has come from the government, the Bank of England, insurance companies, pension funds and even during a particularly fraught time in the mid 1970s, the IMF. It is not the purpose of this article to explore what has driven these changes but whichever was providing leadership offered a combination of liquidity and positive attitude.
Following the crisis of confidence that blew up during July and August the latter part of that year was relatively calm for equities. At that time, we were anticipating central bank intervention in the form of lower interest rates and support for equities from the corporate sector, either in the form of share buybacks or takeovers. Broadly speaking this is what happened and, even though Northern Rock did its best to shake confidence, sentiment steadily improved. What failed to recover, however, was confidence in the credit markets.
Oil Price
Source: Bloomberg
Performance Of UBS, Merrill Lynch, Citigroup and Morgan Stanley
Source: Bloomberg
Banks remain extremely cautious about committing liquidity, except in the very short term. In contrast, company balance sheets are in good shape and so there is scope for corporate investment to be sustained. The sheer scale of the proposed takeover of Rio Tinto by BHP Billiton is evidence that confidence remains at a high level even though fears of a recession are increasing. Western governments, by comparison, have less flexibility and in the UK, after a long period of increased spending, a retrenchment is anticipated. In the past, the pension funds have provided a foundation for markets and a long term perspective. However, as company schemes have closed to new entrants, this influence has been fragmented and diminished and so we must look elsewhere to find leadership.
There are four main sources of liquidity at present: Asian central banks, beneficiaries of the high oil price (operating as Sovereign Wealth funds), hedge funds and private equity. Although the assets commanded by this group remain small compared to conventional reserves, such as pension funds and insurance companies, all are growing in importance and are forecast to become even more influential over the next few years. In terms of scale, oil money and Asian central banks are broadly similar in size with hedge funds and private equity some way behind.
The investment objectives of these four are similar in a number of ways. Each has the ability to invest for the long term and is prepared to accept risk in pursuit of higher return. This has implications for all markets.
Asian central banks and oil beneficiaries are providing liquidity to many parts of the financial system and because of their longer term time horizon, there is a greater emphasis on equities and alternative investments than might have been expected. As western banks have acted to conserve liquidity, the influence of these new investors has increased, as has their ability to set the price for any particular deal.
The well publicised problems of the high profile and highly leveraged Bear Stearns hedge funds, together with disappointing investment returns in July and August, stimulated the hedge fund obituary writers to raise their heads above the parapet once more. In the event aggregate hedge fund performance was the strongest versus equity markets since 2002, outperforming the US equity market by over 5%. Well managed funds have liquidity and this gives them pricing power particularly in the absence of any serious competition from the banks. Good returns have not been generated by higher borrowing or increased risk, but rather by extra opportunity resulting from more volatile markets.
Private equity has had a roller coaster year. Just a few months ago, the industry was under attack for excessive profitability and now, because of increased risk aversion, the private equity business model is thought to be under threat. On balance, I suspect that private equity will play an increasingly important role in financial markets over the next few years and that institutional investors will continue to increase exposure. To start with, $4.5 trillion of deals completed in 2007 will have to be sorted out and there will always be under performing companies that are in need of attention.
The concentration of liquidity with Asian central banks, oil producers, hedge funds and private equity has proved helpful to financial markets. They have invested in a broad range of assets ranging from illiquid higher risk areas to US government bonds. It is no surprise that a number of leading financial institutions such as Citigroup, UBS, Merrill Lynch and Morgan Stanley have raised new capital to repair their balance sheets from these investors. The terms of these deals are uniformly attractive to the buyers and indicate the weakness of those requiring funds.
In summary, markets have received a significant shock over the last few months and further problems are likely to emerge. Credit fuelled growth is over for this cycle, but on a selective basis investors should be looking for opportunities to invest in equities in order to take advantage of attractive valuations and hedge funds positioned to take advantage of higher volatility.
In the short term following the action of those with liquidity seems about right if you want to judge the direction of financial markets over the coming months. In the medium term all leading economic blocks and their central banks remain focused on economic growth and this offers some encouragement during these turbulent times.
Download January's Monthly Note in PDF file format