Premise
Janet
Yellen, Chair of the US Federal Reserve Board of Governors, has said she does not
expect a 2007-2009 financial crisis in her lifetime. For many reasons we hope
that she has a long life. One of the lessons learned from lots of sports,
including horse racing, and applied to business, portfolio management, and life
in general is to be conscious of what could go wrong. If you will “the known
unknowns” as well as making some allowance for “the unknown unknowns.”
As an investment fiduciary I feel it is essential that one develops an appreciation for the odds that Ms. Yellen may be right.
As an investment fiduciary I feel it is essential that one develops an appreciation for the odds that Ms. Yellen may be right.
What Causes
Crises?
Major financial crises typically have both preliminary causes and a
galvanizing event. The preliminary causes are relatively easily to spot, often
by looking in a mirror. The event is often the unintended consequence to an
action that forces many to brutally re-examine an intellectual or emotional
structure in which we had total faith, that suddenly is found wanting.
Underlying
Causes
The
first cause is the belief in the inevitability of a pre-determined future. The
growing enthusiasm for this belief overrides all past cautions. Because we all
believe that we should be richer than we are, we will borrow to multiply our
stake in the inevitable “goody.” Often
people and institutions look to borrow from any available source including surreptitiously
from others without their notice... embezzlement. Thus, the essential second
underlying cause for crises is leverage.
(For my mathematical readers- Enthusiasm in the “inevitable” times expanding
use of “cheap” leverage = precursor of crisis.)
Where
Are We Today?
Chair
Yellen can not identify any major causes for concerns. She is right at the
moment. Focusing on my continuing analysis of the global mutual fund business,
I see some potential worries.
Are
Equities About to Take Off?
One of
the reasons that mutual fund performance is so often quoted by media,
academics, and even government officials is that the data is quite accurate and
rapidly and relatively available. I have been following these numbers for fifty
years. This how I start to view the movements in the marketplace. On Friday we
finished the first half of 2017. While the data is preliminary and subject to
minor modification, it is instructive. There are at least nine investment
objective averages producing double digit returns for the
first half. (A copy of the list is available by contacting me. The leading
investment objective is the Health & Biotechnology average of +18.46%) Without dividends both the Dow Jones
Industrial Average and the S&P500 were up 8% and using the Vanguard S&P
500 Index fund’s total reinvested return was 9.3% as a rough guide to the
market.
In
terms of our analysis, the key point: if the fund and general market
performance produced high single digit gains in the first half, is it a
reflection of growing enthusiasm which is relatively higher than the current
sales, operating earnings, earnings per share or dividend growth? Remember that
most institutions such as pensions and endowments have a targeted goal of
between 4 and 9% for the year. The biggest gains were experienced by Growth
rather than Value-oriented funds. Growth enthusiasts tend to be more future-oriented
than value investors who are basically betting on correcting mis-priced
securities. Either the markets are now premature in discounting future growth or
will be in the future. Thus, we may begin to exhibit one of the standard precursr to a crisis.
Could Fixed
Income be a Trigger?
The
thirst for income is a global phenomenon to pay current or future bills. Almost
everywhere that has a sizable Mutual
Fund marketplace, money is pouring into bond funds at the retail level and into
other credit instrument funds at the institutional level. What makes this
concerning is the general market perception that interest rates will rise, and
if things go wrong the rise could be significant. While Fixed Income investors
typically focus on yields on purchase price, they are often shocked when they
sell at prices below their initial purchase price. At some point at least the
institutional investors will look at their investments on a total return basis
incorporating current prices which could be materially lower due to interest
rates rising. Future prices could be hurt by various trading entities like
hedge funds being forced to meet collateral calls as their Fixed Income
holdings are marked down to a declining market. My own suspicion is that the
two segments which are most exposed to high leverage is government issued paper
and credit instruments.
Archduke Accident
Replay
Popular
beliefs hold that World War I was begun as an outgrowth of the murder of the
popular Archduke Franz Ferdinand of Austria on an automobile route in Sarajevo that
had been changed due to security precautions from an incident earlier that day.
The change was ordered without telling the chauffer. The
sad event set in motion countries that were already preparing for war and
forced their allies to come to their aid. Often the trigger events are caused
by an unintended consequence of a well intentioned act, often by some force
within the government. Usually the forces that trigger the consequences have a
much too narrow of a view of their impact. Allow me to suggest a hypothetical
and probably improbable series of events.
Government
officials and media pundits look at mutual funds as products with a sole goal
of producing a higher return than some other measure. They fail to understand
the history of the fund business. Mutual Funds started as a way to mobilize
existing savings (usually on deposit) into long-term investing. To convince savers to part with some of their
savings was not a simple exercise of giving the reluctant saver enjoying a
level of security something to read. The sales process often took a number of
sessions. The global fund business was a financial service activity not a
financial product producer. Perhaps the key value of these financial
services is not just the initial purchase, but subsequent purchases. Probably
the greatest value during periods of scary market declines is urging the
investor to stay invested. Finally, the process permits and encourages partial
withdrawals and perhaps some switching into more appropriately aged
investments. All of these services need to be available everyday and often in
aggregate, cost more than the pure investment expenses. In recognition of these
needs many fund distributors and allocators have styled themselves as wealth
managers.
The
UK’s Financial Conduct Authority is complaining that UK funds are not competitive enough. They want competition
based on a single fee covering all the holder’s costs and performance. (They
are not focusing that in many cases the services aspects of the fund business
are equally or more important to the holder than fees and performance.) We have
in the past seen similar naivety occasionally in the US. Some similar concerns
had been expressed in the EU’s MiFid rules.
What Could Go
Wrong?
For the
moment assume that this type of thinking becomes popular in many countries,
sales people and to some degree, service people will leave the fund business
and migrate to more expensive products and services like hedge funds, private
equity, venture capital, real estate, or “investment art.” There is some chance
that the returns will be below mutual funds. Where this could create a large
problem for various governments is that the growing retirement capital deficit
is expanding and there will be pressure on taxpayers to fill the gap at the
expense of other government services. Expanded government services will lead to
higher inflation as the government will have to borrow more to pay its bills. Or
taxes will rise which can in and of itself cause a financial crisis as
taxpayers rapidly change their investing status.
What
Are the Odds that Janet Yellen is Correct?
At the
track regular horse players understand that in spite of all their considerable
handicapping (analyzing) skills there is something called “racing luck.” Things
happen that are the providence of the “unknown unknowns.” Ms. Yellen could luck out and
there won’t be a financial crisis the rest of her life.
For my responsibilities I am prepared to have to deal with some or more of these. I am growing particularly nervous over the next 18 months as governments that in general have a record of creating unintended impacts cope.
Both the US and India are early in redefining their tax structure, France is going to attempt to become competitive through labor reform, China is restructuring economically and financially, and there is the little matter of Brexit.
For my responsibilities I am prepared to have to deal with some or more of these. I am growing particularly nervous over the next 18 months as governments that in general have a record of creating unintended impacts cope.
Both the US and India are early in redefining their tax structure, France is going to attempt to become competitive through labor reform, China is restructuring economically and financially, and there is the little matter of Brexit.
One may
need good advice now more than just faith that there won’t be any crises.
__________
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A. Michael Lipper, CFA
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