Markets are forward-looking. There are three sides to the ‘markets’ story. There are savers, investors and middlemen, who make their money by connecting savers to investors. Over the last 30 years, the middlemen have exploded in size and ambition.
Writing in the 1990s, economists could credibly buttonhole ‘financial intermediaries’ into simple categories: banks, pension funds, insurance companies and ‘other’, where ‘other’ included hedge funds, venture capitalists and a few other specialised money management services.
Today, any categorisation of the ‘other’ column quickly runs into ‘angels on the head of a pin’ territory. Everything from derivative traders to vulture funds to exotic investments like sovereign debt of defunct countries to shadow banks to algorithmic traders to guys sitting in the basement of their mother’s house in their underpants staring at a screen ‘prop’ trading. It’s all there and it is huge.
The relentless rise of the ‘other’ column is called financialisation. One thing we’ve seen in small open economies that experience financialisation like Ireland, Iceland, Malaysia and the daddy of them all, Hong Kong, is that the finance industry quickly becomes the most important sector in the economy, and any policy which might harm the interests of this sector of the economy quickly gets euthanised by highly risk averse politicians.
In the Irish context, think about how Irish politicians would react to a policy of increasing the headline (not the effective) corporation tax rate. Or imagine how the denizens of the IFSC would react to the introduction of a financial transactions tax.
This happens when the fortunes of the financial intermediaries take a turn for the worse, so do the fortunes of the country.
Think about Ireland’s reliance on credit from the rest of the world during the construction boom from 2002 to 2007. This credit came through domestic banks, largely, and then was sent out via British and European banks. Any interruption to this process in, say, 2005, by the political system would have spelled the end of the government here. Nothing like this was even countenanced, as we now know, thanks to the banking inquiry.
Markets are forward-looking, as I’ve said. But they also tend to be volatile. And now the players in the markets are very large indeed. The combined assets of Commerzbank and Deutsche Bank, two large German banks, clocks in at around $2 trillion. That’s approximately two thirds of Germany’s GDP. This means anything that affects the fortunes of these big banks affects the fortunes of the fourth largest economy in the world, and the eurozone. The leaders of these banks know it. That’s financialisation.
Imagine you’re an investor working for, say, Goldman Sachs. You want a nice bonus to justify the existential angst which must inevitably build up when you’re a razor sharp, well-educated person working horrible hours doing something of no social use whatsoever.
You have four buckets in front of you. One is labelled ‘sovereign bonds’. One is labelled ‘commodities’. One is labelled ‘equities’, and one is labelled ‘cash’. Choose the right bucket and your bonus is in the bag. Choose wrong and you’re screwed.
What has financialisation got to do with investment?
Right now there are four fundamental forces moving the world’s markets. First, the global supply of money printed by central banks has never been larger, nor has it ever been cheaper. Interest rates are at extremely low levels. When I say extremely low, I mean historically low. The Bank of England hasn’t had a period like this since the 1690s. Combined with the European Central Bank’s outright monetary transactions and quantitative easing programmes, yields (the return you get for investing in assets) on major sovereign debt holdings are very low. Combined with low inflation and low global growth, this is a cause for extreme worry.
The IMF has told the world that its existing forecasts, which expected increased world economic growth of about 4 per cent in the second half of 2015 were now out of date (which is code for wrong) for most of the world’s largest economies. Growth had already fallen short of its predictions in the US, the eurozone, Japan and a lot of the developing economies. Now they are saying growth will be closer to 3 per cent across the globe.
The price of major commodities such as oil, coal and copper are falling, imperilling the fortunes of countries like Saudi Arabia (oil), Kazakhstan (gas), Venezuela (oil), Brazil (oil and coal), Chile (copper) and Peru (copper). Oil is at a three-year low. Copper is at a six-year low. Coal is being replaced by renewables and so its price is also low. Financial products connected with these emerging economies are, perforce, tanking.
The Chinese economy, the lynchpin of the global supply chain, is faltering, as it experiences perhaps the largest Minsky cycle in the history of the world. It has extended too much credit to develop its domestic economy, improve average living standards and move from a manufacturing-based economy to a services-based economy. Now there must be a retrenchment as its industrial production slows, retail falls and unemployment increases.
Forward-looking capitalists will try hard to get their money out of China, looking for better pickings in places like Vietnam, India, and the more developed states of Africa.
So any product connected or correlated with China and its woes will also, perforce, tank. Finally, and perhaps fatally, there is the global savings glut.
Macroeconomists call anything that you don’t consume out of your income saving. So if you earn €100 and consume €80, the €20 left over is saving. It doesn’t matter what you did with that saving. You might have paid down debt, burned it in a fit of pique or stuck it into your pension fund. It’s all saving to us. Globally, savings are at their highest levels ever. Where does this global saving ‘glut’ come from?
Two places. First, the large savings deployed by the baby boomers of the US, Europe and Japan to fund their retirements. Second, the large saving pile in China, where culturally a savings rate of around 30 to 40 per cent of one’s income is seen as appropriate. (In contrast, during the 2000 to 2007 boom, Ireland’s savings rate averaged 1.5 per cent).
These savings have to go somewhere, and do something, in order to become investment. These savings earn fees for – guess who – our financial intermediary friends, but they don’t help produce greater global growth, and that means the required growth in the real economy just won’t come. The money will stay there, effectively under a mattress, doing nothing.
Because there’s so much cash around, you won’t earn anything from putting your money in the ‘cash’ bucket, either. So what do you do as an investor?
You jump around, from bucket to bucket, trying to find a little bit more yield here, and a little more yield there. And all this jumping is called volatility. And who gains from volatility? Well, obviously some people know more about, say, Peruvian copper, than others. So buying now makes sense for them because of their informational advantage.
Others are trying to ‘not lose’, which is a different strategy. Some are making lots of short, small bets, hoping one pays off, big time, to cover the losses.
In the end, those facilitating each mad dash trade make serious money on each transaction, whatever way the bet goes. The house always wins.
It doesn’t matter if you believe in the ‘secular stagnation’ thesis, where productivity gains from technology get worn away by an older population and low interest rates, or the global savings glut thesis, or the Minsky thesis. In the end, your portfolio won’t generate large real returns, that is, returns adjusted for inflation, unless you’re doing something special.
Under conditions of market volatility, many trading strategies, such as ‘buy and hold equities’ or ‘sell copper, buy gold’, will start performing quite poorly.
Even the most basic diversified low-fee indexing strategy, something like the Vanguard product in the US – which we really need here in Ireland, with so many unpensioned private sector workers – will start to look a bit crap, even though it will probably beat most professional fund managers over the medium term.
Impatient investors want yield now, and they want big returns. But it ain’t gonna happen. Forward-looking or not, we are in for a period of low growth, low inflation, and low yield for some time to come.
It’s not the end of world, and people shouldn’t see it as such. The fund managers might not get their bonuses, but they’ll adjust.