I have since mid-May been negative on European growth and cautious on the outlook for risky assets and commodity markets globally. Leading indicators of growth in Europe suggested a slowdown ahead, and there were some ominous emerging developments in funding markets for European sovereign debt with obvious negative implications for the banking sector. The commodity market rally since August 2010 associated with the second round of quantitative easing in the US had in Europe driven up both realised headline inflation and expectations that it would persist, if not accelerate yet my view was that with sentiment and positioning in crude oil both very stretched, slowing prospective growth and the likelihood of lagged responses to past rate hikes starting to become realized, we would see at the very least some stabilization of inflation, with the chance of a more serious downward correction in commodity prices (particularly crude). Stabilization in commodity prices was all that would be needed to bring down headline inflation over the coming six months.
Nature has smiled on us, and we have seen a wondrous rally in German fixed income, with the Schatz rallying 210 cents and the Bund fifteen points since I pointed out the fundamentally-supported breakout in May. Commodities overall have been stable, with sharp declines in crude and copper being offset by continued strength in agriculture and precious metals. The S&P was off a peak of 17% from the breakdown point to its August trough, with the DAX off almost 30%, and the FTSE off almost 20%. The short US/long Germany trade that I favoured in two year fixed income has moved 106 basis points.
Although in May I explicitly confessed my concerns over the possibility that the ECB was mistakenly hiking into a severe slowdown, just as it did in July 2008, and thought that there were other reasons to fear the possibility that the coming slowdown represented something more like a 1937-like resumption of a depression, this was never my primary scenario, and I now believe that there are other reasons to think this was more like a terrifying nightmare whose memories will fade as the present atmosphere of extreme gloom dissipates.
In our age, very few market participants have a strong grasp of financial, economic and societal history. For most of us, history tends to begin with the first point on a Bloomberg chart, and whilst we may avidly consume pre-digested financial histories by econometrically-oriented historians, these are a poor substitute indeed for developing a sense of what it was actually like to live through past episodes. It is easy to scorn the apparent naivete and ignorance of past generations when one knows how the story ended and is unaware of the prior history that led them to form such rudely-falsified expectations.
I have believed since late 2008 that the years ahead would not constitute a depression exactly, or at least not in the modern sense of the word that disproportionately emphasizes the experience of the US in the 1930s and unduly under-weights previous long-lasting ‘difficult periods’ that were a repetitive feature of growth for the previous century and a half in the industrialized world. It was also my view that neither would it be something like a repeat of the Japanese experience – there were particular idiosyncratic features of that episode and I considered it foolish to make very wide inferences with much confidence from a single sample.
Instead, I thought that the period following the ‘Great Moderation’ would be characterized by short, sharp fluctuations in the business cycle somewhat reminiscent of the ‘stop-go’ experience of Britain in the post-war period. In the case of Britain in the past the ‘stop’ episodes were induced by skill shortages and a balance of payment constraint but the years ahead may face rather different constraints. Going forward, the ‘stop’ episodes may perhaps be induced by a variety of factors: supply chain disruptions (as we have seen post the Japan quake), geopolitical concerns (as we have saw following turmoil in the Middle East), earth changes (Icelandic volcano disrupting European air travel) and fluctuations in animal spirits.
During periods of long booms, animal spirits are elevated and credit growth is quick to ‘fill the gap’ in global aggregate demand when there are setbacks of some sort; during extended periods of busts, animal spirits are more subdued and entrepreneurs and consumers are not as confident in increasing borrowing to ‘fill the gap’ in global aggregate demand when a setback arrives. Policy can only truly respond with a significant lag, and if the shortfall in demand is large and sustained, so it makes sense to expect demand to be much more violent in its fluctuations. The very fact of greater fluctuations tends to mean that small moves are less damped (whereas the building in of more insurance via greater inventory and the like will perhaps tend to be effective in damping larger moves). Since we are not yet used to these kind of setbacks, every one of them for now feels like a near-death experience. The future belongs to those who are sufficiently resilient and organized in such a manner that they can look beyond such setbacks towards ultimate goals rather than becoming distracted by the noise; those who are used to responding in a more fluid manner to circumstances as they unfold will risk becoming thrown off course by the unaccustomedly violent disturbances in the tide.
Whatever the precise drivers of a regime change, I think the very predictable, smooth and uninterrupted expansions that in the post-war US experience we became accustomed to treating as the norm will not be repeated for some time. If I am right, then there are very interesting implications for appropriate structures and policy across the business and investing world and many developments that we have come to think of as best practice will need to be revisited.
One notable lesson is that the fashion for managing money under very tight and focused constraints will encounter the realization that in the new regime there are very much greater opportunity costs for behaving in this manner. Tight, monthly stop-losses introduce brittleness and extreme path-dependency into the investment process that the wilder markets in our future will not treat kindly. Instead one will have to adapt to operating with lower leverage, scaling into and out of positions, managing to a longer-time horizon and having less precision about the path that equity might take along the way to the longer-term. If one cannot control risk as tightly, it becomes much more important to be discerning in manager selection and in identifying ahead of time the market environment that one is in.
Changes to the nature of the business cycle constitute one reason for greater wildness in the new regime. Another is the more or less complete replacement of the specialist and other system-created stabilizing sources of speculation with high-frequency trading algorithms. (See the recent speech by the Bank of England’s Haldane on this topic). The bargain we have made is that in normal times we pay a significantly lower turn in transacting orders of normal market size, but that in the absence of the specialist we have many more instances of wild moves in markets, the flash crash of 2010 being just one headline-catching example of a phenomenon that takes place at all time horizons, from the very short term to the medium term.
The implication of this is that patient, long-term, reflective capital has the opportunity to earn very significantly enhanced returns from engaging in market-stabilizing transactions. These sharp, wild moves allow discerning investors to accumulate already-cheap assets at even cheaper prices and to sell already-expensive ones at even richer ones. But one has to have done the analysis previously and to be able to identify propitious moments and levels to fade such market moves whilst understanding that it may be impossible to achieve perfection in timing.
Unfortunately, this change in market infrastructure occurs at a time when such investment capital seems to have become especially scarce. When I started working in this business in the early 1990s, I originally believed that markets were relatively efficient but it made perfect sense to me that hedge funds were able to earn superior returns because they clearly had tremendous advantages over then-sleepy real money, being able to act much more quickly, able to be very flexible and opportunistic in the instruments and strategies traded, and to be much harder-working, more diligent and more able than the management of very large pools of assets that were run in a less-aggressive fashion.
It is in the nature of social change that ideas start on the fringe, attract a following by the success of their earliest adopters, and eventually grow to encompass the whole arena, being taken to the largest point at which they make sense and then well beyond that point.
Well, I do believe we are at this stage now with hedge fund strategies as they are popularly characterized. Today, real money, retail and even university endowments try to trade in a hedge fund-like manner; very high quality, timely information is available at very low cost to a broad audience, and the traditional sources of advantage once available to those who pioneered the hedge fund industry are in many cases depleted.
Yet if I ask myself whether this means that no sources of opportunity remain, this is clearly not at all the case. The game has come full circle, and the advantage is actually now with those who rely not on special sources of fast-moving news but rather on their ability to reflect on and integrate widely available public information to arrive at a variant perception of valuation and then who have the patience to await attractive junctures to express these views in the marketplace (and critically to recognize such junctures as opportunities rather than to become distracted by the tremendous gloom that accompanies a bottom and the exuberance that accompanies a top). We have returned once again to “masterful inactivity” as the ideal of the portfolio manager. Rather than keeping up with all the trades that pop up on one’s radar, the greatest challenge in the period ahead may be _not to trade_ until the opportunity is extremely compelling.
In contrast to this ideal model for future investment strategy, we find today that people are very much lacking in belief and faith in anything. During the years up till 2007, most investors paid very little attention to the business cycle, but held an underlying non-rational belief that the Fed was in charge of the business cycle, that inflation-targeting policy would ensure that the era of extreme booms or bust was confined to the distant barbarian past (preceding the Bloomberg first data point) and that one could focus on asset-specific ‘fundamentals’ in making decisions about which assets to own. Since prosperity and the underlying dynamism of the American economy justified the expectations of strong growth out into the future, one could feel confident in expecting very satisfactory returns on equities and could hold a portfolio heavily weighted to equities provided one was a ‘long-term’ investor.
The experience since this past era ended has been traumatizing for such faith. The disappointing performance of hedge funds, macro hedge funds included, led people to favour strategies whose mechanics they felt they could tangibly comprehend. For the rest, investors are still no closer to having fundamental, robust and grounded beliefs about the nature of macroeconomic reality. As a result, we see a tremendous instability and lack of coherence in the beliefs market commentators and investors hold regarding the economic outlook. In July 2008, otherwise perfectly sane, experienced and well-respected market participants calmly assured one that there was a real risk the US would enter hyperinflation very shortly. Only six months later, some of those same participants were concerned about the possibility of a new Great Depression, only much more extreme. And a couple of years after that we heard again about the necessity of holding hard assets against the inevitability of hyperinflation some way down the line. In other words market participants have very few stable beliefs and tend to become very whipped around by the dramatic swings in valuation – when the market has rallied a lot people turn bullish, and when it has sold off a lot they turn bearish. So much for Milton Friedman’s argument that speculation in financial markets would tend to be a stabilizing influence!
Having devoted more than twenty years to the study of business cycles, mass psychology and financial markets, I have over time arrived at quite a stable (albeit still developing) set of beliefs about how the economy and markets operate and intend in this service to offer a counter-balance to the nihilistic tendency of our era to hold only a view consistent with the most recent market move, and to help my clients to perceive and act on the dislocations created by the lack of market liquidity so that they become predators rather than prey.