When the tide turn

When King Canute famously ordered the tide to turn (and failed), it was no act of arrogance, but a lesson to his courtiers that he was a mere mortal. Such humility is sadly lacking with modern financiers who believe that the five-year surge of financial liquidity is a permanent feature. All assets have floated on the swell of this supposed wealth, created by governments and consumers who have binged on borrowed money. To put this into context, the last six years have seen more mortgage debt created in America than in the half century prior to 9/11. While the stock market has rallied for several years on the back of increased corporate earnings, few stop to think of the origin of this money, let alone whether its source is sustainable. Its generation is threefold in nature: from increased mortgages, the diminution of savings and from populist tax cuts (in the case of the USA). We often see that widespread debt creation propagates inflation and when the two elements combine they paradoxically lead to deflation. A clear example of this boom and bust can be seen in Japan over the course of the last 20 years.

Just as food manufacturers manipulate our genetic programming, tempting us to grab and gorge food with the least nourishment, so we are sold investments that are well-publicised and appear to offer an easy return. This happened previously with the Internet bubble and now it is the turn of the property market where once again, people are concentrating too much of their wealth in one area. Many asset managers have lured investors out of cash and into risk assets; no matter the market conditions. This is because bankers are forced to increase earnings year-in, year-out to please mythical long-term shareholders who are more likely to be directors with short-term share options. Lenders have likewise abandoned the old safeguards that stopped their predecessors from chasing unsuitable business. The blow-out in the high risk, US sub-prime mortgage market is a fine example of how restraint and stewardship have long been forgotten. We will have to re-learn these qualities in the most painful fashion in the years to come.

It is the nature of investment and hedge fund managers to extrapolate recent history and make the case for higher returns from here. However, we are in the fifth year of an extended and mature bull market where risk assets have been pumped up by easy money and a one-off consumer binge. The likelihood of this continuing is remote but few wish to face the uncomfortable flip-side of this apparently benign environment; one of puritanical saving and debt reduction, implying a dire outlook for markets. Such accumulation of cash should be venerated and not vilified by bankers, especially now that interest rates are ascending. It provides a nice buffer against the volatility of markets and offers a relentless compounding effect as interest steadily accrues. While deposits may give investors peace of mind, they do not generate much by way of fees and commissions.

Risky assets have had their day and it is now time for the tortoise to overtake the hare. While investors have been comforted by phrases such as diversification, it is clear from the last few big declines (usually in the spring) that asset classes across the board are becoming more and more correlated on the downside. In the past, a mixture of equities, bonds and alternative investments would have given one a ledge to cling to, at least for part of the portfolio. When a downturn is encountered nowadays, the good is sold with the bad to offset losses elsewhere because so many aggressive speculators are geared to the hilt. In effect there is no hiding place when markets decline which is probably why the advance/decline ratio in the snap February sell-off was one of the worst on record. In the meantime we need to preserve our purchasing power from inflation and the devaluation of mainstream currencies. This can be achieved through investment in precious metals, commodities and other ‘hard’ assets. Even these assets would be dragged down in the short-term so a large dose of liquidity is advisable. If a downturn were to unfold in future, we may then witness the classic response of competitive devaluations followed by protectionism; the antithesis of globalisation as we know it.

Like a steel spring that has been stretched beyond its limits, Western economies run the risk of permanent damage and deformity. The overdose of debt and speculation that made Anglo-Saxon countries appear rosy-cheeked on the surface have in fact left them on the verge of toxic shock. The assets that were elevated on the incoming tide face being dashed on the rocks as the easy money ebbs away. We should therefore use any rally in markets between now and summer to lighten our load of risk assets and learn some old-fashioned habits of saving and financial sobriety.

May 2007

Toby Birch aka Hugo Bouleau
Author of The Final Crash