“Confusion is a word we have invented for an order which is not understood.”
– Henry Miller.
The response of certain market participants to recent financial turmoil “reminds me of the way five-to-seven-year-olds play soccer: players on both teams tend to chase the ball in the manner of a noisy herd. They are, in effect, totally data dependent. Their approach stands in sharp contrast to the behaviour of older kids. Anchored by a better understanding of the game and more of a strategic mindset, the older players seek to maintain positions on the field and rely more on letting the ball do the work.” A particularly apposite image from Mohamed El-Erian’s just published ‘When Markets Collide: investment strategies for the age of global economic change’ (McGraw-Hill, 2008). Few things seem more descriptive of the modern investment community than a mob of squawling brats confusedly in pursuit of a now invisible ball. August, of course, has long had a reputation for being the silly season of the markets, when fresh-faced juniors are left to kick prices about while their supposedly more experienced and emotionally balanced bosses hit the beach (and this year, probably the bottle as well). But Mr El-Erian, a veteran of the IMF, the Harvard Management Company, and most recently bond giant Pimco, within one image gets to the heart of the problem with current financial volatility: the signal-to-noise ratio has collapsed in favour of noise, and reacting to marked short-term swings across multiple types of assets (bank stocks, metals prices and currencies to name just three) now has the surreal feel of frantic fire-fighting even as a nuclear winter threatens.
Rarely have the short-term market outlook and longer-term financial prospects appeared more divergent. With oil prices finally off the boil, belatedly reflecting the likelihood of synchronised international recession; with gold having broken widely followed technical support at $850, and with the US dollar resurgent, few investors would likely bet against those trends continuing over the balance of this year. But over the longer term (say, 12-24 months out), who would realistically bet on them continuing ? The world may not be running out of oil, but it certainly seems to be running out of cheaply accessible oil, and the regimes where it has selfishly decided to deposit itself are typically those most hostile to those US interests that have singularly failed strategically to adjust their economy’s hydrocarbon dependency over the last three decades.
Gold may well suffer in the short term as all things commodity-like get dumped, and as the US dollar enjoys a fleeting dead-cat bounce whilst the rest of the world economy suddenly looks a lot worse than North America’s. But at a time when both fiat money and the global banking system have never looked more precarious, sub-$1000 gold now looks like relatively inexpensive portfolio insurance. And while the tailwinds now support the US dollar on a “lesser of three evils” basis versus EUR and especially GBP, would the average long-term and otherwise unconstrained investor really back the greenback over a period when trillions of dollars in sovereign wealth fund assets are going to be looking around both for currency risk reduction and somewhat more exciting portfolio diversification than US Treasury bonds ?
Perhaps most jarringly of all, the short-run outlook for inflationary pressure (distinctly heightened) sits at odds with the likely disinflationary impact of global debt deflation and widespread economic contraction. (And on a related topic, will safe haven flows into government bonds outweigh the possible supply shock of colossal government debt issuance that may yet be required to bail out still recalcitrant and effectively insolvent banks ?) Market timing, in other words, has just become a huge driver of portfolio returns when market opacity meant that we least wanted it to.
The good news, as Mr El-Erian largely implies, is that we need not struggle unduly to position investment portfolios today to benefit from the secular transformations altering the global financial landscape – the longer term strategic allocation is a decision that is, in his words, “important but not urgent”. Those secular transformations have not gone away; they have merely been disguised by the smoke and noise of a highly emotionally charged trading environment. Those transformations include the wholesale realignment of global economic power and influence “including a gradual hand-off to a set of countries that previously had little if any systemic influence.” Allied to this hand-off is the accumulation of financial wealth by the so-called sovereign wealth funds, and by countries that in some cases are more used to being debtors and borrowers than creditors and investors – so our perceptions of the recent past will have to be carefully overhauled. The third transformation cited in ‘When markets collide’ is that caused by the proliferation of new financial instruments that have profoundly changed the cost of entry to many markets. On this point one feels that Mr. El-Erian may be overly sanguine in his implicit praise of financial innovation. Wall Street interests are those that brought us the sub-prime disaster, and those same Wall Street interests are likely to be radically transformed in its aftermath – if they survive at all. A Greenwich Associates survey of 146 institutions indicates that investors expect at least one more big financial firm to collapse within the next six months. A more outspoken commentator, Nouriel Roubini, Professor of Economics at New York’s Stern School of Business, has suggested that not one major investment bank, including Goldman Sachs, will survive through the credit crunch and wholesale deleveraging climate, because the investment banking business model is simply no longer viable. Post-Bear Stearns that supposition is, however, increasingly moot, given that the US authorities, and what passes as the financial administration in the UK, have become increasingly explicit in their willingness to support even second-tier banks and intermediaries of dubious worth.
The pragmatic conclusion ? Shepherd your capital defensively through the current storm, with a view to benefiting from longer term secular trends – not least, a shift away from Anglo-Saxon economic dominance – in the fullness of time. Attractive longer term markets are likely to be those that have already enjoyed sustained periods of outperformance over the most recent years – the likes of China and India which are undergoing a post-industrial revolution of sorts, and the natural resources markets that are fuelling them – but over the shorter term, pragmatism dictates a focus on capital preservation and extreme risk- or loss-aversion. In terms of timing exit and potential re-entry, the information conveyed within price history charts will be as useful as anything, particularly noisy and largely subjective “fundamentals”. One exception, perhaps, being gold – where notwithstanding shorter term price weakness and a resurgent dollar, the macro backdrop of global financial crisis, stubborn inflation, and the more or less complete lack of confidence in modern finance and financiers points to one of the most supportive fundamental environments in decades.
Originally published at The price of everything and reproduced here with the author’s permission