After Goldilocks

“Today you can go to a gas station and find the cash register open and the toilets locked. They must think toilet paper is worth more than money.” – Joey Bishop.

The so-called ‘Goldilocks’ economic environment, writes Peter L. Bernstein, was aptly named:

 

“low volatility in capital markets and in the real economy, low inflation, central banks in firm control, a healthy appetite for risk-taking in the business world that led to revolutionary technological change, the transformation of the ‘emerging’ economies into ‘developing’ economies, and the resulting boom in globalization.”

 

Bernstein suggests that after the dotcom bubble messily burst in 2000, the business sector was slow to regain any appetite for risk-taking. For this reason, Goldilocks lasted longer than she might have done. But as stability reigned and the global economic system effortlessly grew, in time-honoured fashion it was the banks that stepped in where more intelligent businesses might have feared to tread, and ratcheted up the dial for risk. In equally time-honoured fashion, the housing market became the focus for renewed risk-taking, aided by two deadly contemporary trends: rapidly rising prices, and financial innovation. Three, if you count leverage. Now, “in the aftermath of the fervour for risk-taking, Wall Street and the mortgage banks have created many deep-seated problems for themselves. As an unhappy side effect, the business sector, a relatively innocent observer, is going to have to absorb much of the pain of curtailed consumer budgets and fewer exports to foreign nations affected by the turmoil in the US.”

 

In a letter (“The Shape of the Future”) republished by John Mauldin in his ‘Outside the Box’ column, Peter L. Bernstein goes on to suggest that far too much time is given over to analysis of the present or the anticipated near term – “the short run always tends to dominate mass thinking in any case, but in an odd way the short run is irrelevant to the current situation.. As Goldilocks shreds, we have to start thinking about what kind of long-term environment is going to replace it. Shifts to new environments are always attenuated. They are also rare across time, which means most of us have limited experience with this phenomenon. New environments often tend to sneak up on us and do not announce themselves with a fanfare. Most of us are unaware of what has happened until enough time passes to provide good perspective.”

 

As one might expect from the author of ‘Against the Gods: the remarkable story of risk’ (one of the finest books written about the risk inherent in investment, and the ways to study it), Bernstein’s letter does plenty to encourage longer term contemplation of the state we’re in. Extrapolating just from the short term, the very nature of the western financial system is likely to change profoundly. A badly bruised credit system will take some time (longer, probably, than many commentators suspect) to recover its health. And it may never regain the lofty heights to which it has recently reached, through a combination of economic retrenchment and more intense regulatory friction. As Bernstein points out,

 

“Without securitization, and without the lively derivatives markets that developed around the securitization process, the entire credit system loses an immense source of capacity, hindering deserving borrowers in search of financing and, as a result, the pace of economic growth.”

 

With trust in financial institutions, primarily banks, in total disarray, rebuilding that trust will also take longer, most probably, than many expect. “The pace of change in that direction, however, will be slow, a matter of years rather than months. An entire structure has crumbled and has to be rebuilt, brick by brick. The impact of unforeseen but inevitable credit problems will loom large, detouring and delaying the pace and patterns of recovery on each occasion.”

 

Bernstein’s central argument is that the cause of recent financial market turbulence, the effective bankruptcy of the western banking sector, of an unsustainable rise in leverage combined with opaque financial engineering, came about not from too much inventory nor overexpansion in industrial capacity, not from a burst of inflation requiring tighter monetary policy, but

 

“The root of today’s problems in the financial markets and in the economy as a whole is the household sector.. the shrinkage in the personal savings rate [in the west, at least] is not the result of consumer profligacy, as other commentators persist in describing it. Rather, the savings rate has been suppressed by a slowdown in the growth of household incomes. The shortfall.. has been met by borrowing, and in particular by borrowing against the family real estate. Now the opportunity to borrow has shrunk dramatically, an outcome that will profoundly change the household’s spending power and spending patterns. But the impact is not just on the household. A slowdown in the growth of consumer spending has ominous implications for the entire global economy – and, along the way, the US [and other western sovereign nations’] federal deficit, soon to be overburdened by spiralling benefit obligations. This predicament is not a short-run matter..”

 

Quite what emerges from the reconstituted rubble of the financial system, in however many months’ or years’ time, is obviously unclear. But it seems a reasonable bet that banks as we know them will play a smaller role in the future, constrained by both regulatory fiat and by lingering recollection of how much damage they have spread among a broader and largely blameless economic community. Much doom-mongering has been deployed over the rise of the so-called shadow banking system. Inasmuch as this relates specifically to hedge funds, while the stupidly overleveraged or just plain stupid will continue to go to the wall, there is no reason why the hedge fund sector (to the extent that it constitutes just one homogenous group) will not continue to attract assets at the expense of older and less relevant investment structures – such as the venal and poorly named mutual fund complex, where conflicts of interest between asset gatherers (or euphemistically, asset managers) and investors continue to reign supreme.

 

On this note, last week’s piece by E.S. Browning for the Wall Street Journal (“US stocks’ lost decade”) will have made many traditional fund investors feel distinctly uneasy. Despite the ongoing refrain from the fund management community about investing for the long run, since 1999 the stock markets of the US and the UK have gone.. nowhere. More precisely, taking the S&P 500 Index as a proxy for the broader US equity market, US stocks are exactly where they were nine years ago. Stocks over that period have been beaten by Treasury bonds (an outperformance that both Gilts and Treasuries will struggle to repeat given the parlous state of government finances and the further deterioration implicit if Bernstein’s thesis is correct). The performance of UK stocks over the same period has been even worse. Whether expressed in the form of the FTSE All-Share or by the FTSE 100 Index, UK equities are now worth less today than they were nine years ago. Given that we have just been through a period of extraordinarily benign global growth, that is some achievement.

 

It is not all bad news. Investors today benefit from products and vehicles that simply didn’t exist in anything like their current form nine years ago: low-cost exchange-traded funds (if you resent your fund manager – do the job yourself !); closed-ended listed hedge funds and funds of hedge funds; exchange-traded commodities and precious metals trackers; capital guaranteed structured products.. Not only are equities no longer the only game in town, even if they were, there are now a myriad ways of slicing and dicing market risk to the appetite of the individual investor. And some of the investible themes are little short of compelling. In a piece for the FT’s Insight column in early March, Barclays’ Tim Bond compared the recapitalisation required by the banking system with the funds required by the global energy complex. While estimates of the banking capital shortfall vary from $300 billion to $1,000 billion, that compares with the prospective capital requirements of the resources markets:

 

“According to the International Energy Agency, the global energy sector alone needs a real $22,000 billion over the next two decades to meet the anticipated rise in primary energy demand.”

 

If that doesn’t look like an investment sector that will repay careful study, it is difficult to know what will.

 

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