Constant change is here to stay, says Michael Wilson. And that’s a good thing. But where did all those black swans come from?
Excuse me if I seem to be in a bit of a saturnine orbit this month. I’ll snap out of it, honestly I will. But I’ve just been watching Professor Brian Cox explaining on the telly about how many times our supposedly unchanging planetary system has in fact been wracked over the billennia by unlucky collisions, near misses and gravitational upsets from passing lumps of rock that have continually spun the celestial dice on whether earth lived or, like Mars, died?
Not that our planet gives any particular cause for imminent concern in that department, you understand – give or take the odd half-kilometre asteroid escaping from the Kuiper belt now and then. (There’s a 300 metre specimen passing close by in 2029, just so you know.) In practice, right now, we are far more likely to do ourselves in with self-inflicted environmental damage before the space rocks ever get a chance. But at least we can do something about that, of which more anon.
Closer to home, it isn’t just wandering planetary lumps that can change the gravitational pulls that determine our collective experience. Incoming geopolitical realities like the emergent China, the influential euro, the increasingly self-focused United States and – of course – Brexit itself, have all been moving our financial markets in ways that reflect far bigger economic realities. Or at least, they jolly well ought to. So how well are we keeping up with the changed global environment, and do we need to change our views, or our asset allocations?
Professor Cox does a pretty good job on putting us into our cosmic place, of course, but at the end of the day, he says, the only cosmic constant is mathematics. Which is a bit of an embarrassment really, because we do seem to be hanging onto some 30 year old ideas that don’t always stand up to close inspection.
Now, don’t get me wrong. In the 36 years since I first landed at the Financial Times, I’ve never known a time when there was so much interesting stuff going on. As a self-confessed political nut, I am permanently obsessed with the links between politics and economics, economics and financial markets, and financial markets and prosperity. And there are a few very big questions that I can’t answer.
How is it, for example, that America’s terrifying plunge into fiscal debt hasn’t killed off the US economy’s growth but is in fact creating genuine jobs? How did ten years of quantitative easing (also known as borrowing from your grandchildren) not destroy the currencies of those countries (UK, US, eurozone, Japan) who issued it?
Why do the prices of commodities, including oil or iron or copper, continue to rollercoaster as if we didn’t already know that supply is limited and that we’ll be needing them all for a long time yet?
How are the markets tolerating Shiller p/e ratios of 30 and above, which are broadly the same as they were in 1929? What of the impending top-of-cycle for corporate profits? Have we properly factored in the emergence of China, or alternative energy?
Where, in short, are the fundamentals in all this? And where, in particular, are the mathematics?
Those black swans again
Like everybody else, I am indebted to the Lebanese/American essayist and risk specialist Naseem Nicholas Taleb, for his ground-breaking theory that so-called “black swan events” can change the market in random ways and with surprising speed – and the market’s logic with it. The question, in 2019, is whether we are taking enough notice of the entire squadrons of black swans that seem to be in the air?
Taleb had the good fortune (or foresight) to publish his book in 2007, on the very eve of the global subprime bond and banking crisis that would undermine everyone’s confidence in the perceived certainty of the marketplace. Taleb’s title refers to the wisdom of the ancients that there was no such thing as a black swan – and that, if such a bird were ever to be discovered, the entire logic of any system that underlay that certainty would be subject to re-examination.
On the face of it, then, Taleb’s theory seemed to fit the mood at the close of Alan Greenspan’s nineteen-year splurge of easy-money, feelgood, liberal and mainly Clintonian expansion in the western world. As the easy assumptions about responsible central banking and self-regulating markets fell into doubt, and as banks duly collapsed or had to be rescued, the equity markets took the brunt and the world turned to fixed interest. Which was logical enough, in its way. Once a black swan has landed, you need to reassess things.
Except that America’s bond markets remained super-strong for long after equities had powered their way back to full strength. It indicated (well, to me anyway) that there was a substantial weight of risk-averse money waiting out there for the US market, even though the risk-takers also seemed to be taking their chances with considerable success. Where was it coming from? Abroad, it seemed, and from the emerging markets in particular.
And the thing is, in 2019 it’s still that way. Ken Fisher, the US perma-bull investor, has been telling us British since the dawn of time that neither foolish governments nor major scandals nor profit downturns will dent the eternal natural superiority of the United States. We worry too much, says Mr Fisher. And darn it, he has an annoying habit of being right.
Fiscal dogs that still aren’t barking
But back to the irrationality of the current situation. China’s Shanghai equity scene has been suffering especially badly from America’s bull market since the late noughties – which has often seemed odd, given that its economy has been powering ahead by 8-10% a year for most of that time. Whereas Western Europe’s markets barely held their own, while South America’s suddenly lost much of their allure.
There was only one explanation that seemed to fit the bill – namely, that America’s quantitative easing programme (which started in 2008) was somehow hoovering the liquidity out of other large markets. Wasn’t that rather odd, given that the US was plunging into debt at such a speed?
Well, possibly. You could, of course, protest that China was indebting itself even faster than America, and with rather fewer controls. But against that, at normal times investors are prepared to allow more latitude for large, fast-growing states like India or China with vast untapped consumer potential. And the thing is, this time they weren’t doing so.
In the present day, as Donald Trump’s United States barks and threatens its way to international trade dominance, the feeling seems to be that the new global reality might be here to last. As we approach the roaring twenty-twenties, it does sometimes seem as though political sentiment has indeed swung back toward the US in a way that negates anything we might have believed about the traditional relationship between economies and financial markets. But is that strictly true? Let’s examine the evidence.
If we look at China, we see the beginning of the end for the public infrastructure boom and a growing concentration on the domestic consumer, which is what you might call the second “maturing” phase of industrialisation. So far, so promising.
At the same time, we are also about to see China flexing its rare earth muscles – possibly the country’s best defence against overweening trade pressure from Washington. (Rare earths, needed for all kinds of high-tech gizmos, are found all over the world, but only China is currently able to extract them cost-effectively.)
The perpetual lure of the safety play
And yet the markets still don’t fancy China: my Fidelity China Special Situations IT shares have lost 15% in 17 months. Is it that investors are worried about non-performing bank loans, which are still kept too obscured for comfort? Is it that they’re mystified by the central bank’s rumblings about a looser monetary policy? Or is it that they’re frightened by the uncertainty from Trump’s aggressive trade posturing and are flocking to shelter behind the bully in the playground?
We don’t know. What we do know is that the old “refuge currency of last resort” has been funnelling cash away to the US in recent years, and the fact that China is now holding $1.125 trillion of dollar paper – an amount that ought to give Beijing some serious leverage! – doesn’t seem to be carrying much weight at all.
They tell me that China is building its forex reserves ($3.3 trillion)so as to drive down the value of the renminbi yuan and keep the country’s exports cheap. Which would seem to suggest that Beijing wouldn’t be any hurry to sell them off, no matter what anybody says. So the dollar juggernaut rolls on. There are no black swans to be seen there, it seems.
The eurozone, of course, has better reasons for defying the usual wisdom about how every tide will have to turn eventually. Its woeful economic performance is barely in positive figures; its political system is in semi-permanent disarray; its exporters are seriously worried about Trump’s trade threats; and now the prospect of an imminent British exit, perhaps without a deal, is casting yet another pall over the mood.
And yet there are other global trends which are, on the whole, entirely positive. The question is, are our asset allocations taking account of them yet? No, I don’t know the answer either – I’m just posing the question.
One thing we can say for sure is that demography is now tilting the global balance of equity ownership patterns, probably for ever. As the citizens of the world are encouraged to monetise their own futures by replacing their employers’ funds with their own retirement portfolios (in which they carry all the risk), the demand for safer options, for high yielding shares and for low-maintenance funds such as oeics/ucits (especially passives) has grown.
That seems straightforward enough, of course. But what we forget at our peril is that the sheer numbers of elderly are set to grow strongly over the coming decades, as baby boomers retire and younger workers – who are supposed to support them – fail to supplant them because not enough of them have ever been born.
Only two years ago, the World Economic Forum produced a report suggesting that the OECD developed-world countries would find themselves carrying a pensions shortfall of £334 trillion by 2050 unless its politicians pulled their pencils out pretty sharply. Using calculations based on the idea that a retired person would need 70% of what they’d earned during their working life, the WEF forecast that the UK’s pensioner deficit would soar from £6.2 trillion to more than £25 trillion by 2050.
You can look at this problem any way you like, but over the long term it’s certain to drive people into buying low-risk, low-maintenance products that don’t do fancy things with aggressive growth strategies. But what will those be?
Good question. Any investor, or pension fund manager, who sought sanctuary in bonds at today’s wafer-thin yields – never mind those of the last ten years – may well find that a future capital loss makes a monkey out of whoever told them it was a safety strategy. So have we got the risk balances right? I wonder.
It’s not all bad news for the equity strategists, of course, because today’s globally interlinked markets are big enough and liquid enough to take a lot more knocks than they used to. Just as British investors are able to buy US or Japanese or Indian shares with ease, so foreigners are more interested in buying into the UK.
Even if we exclude foreign-domiciled listed companies in London and confine ourselves to UK-domiciled ones, we find that a majority of their market capitalisation is foreign-owned. The precise figures are hard to pin down because of varied ownership structures, but an Office for National Statistics survey in 2016 put the figure at 53.9%. (Up from 25% in 1997, although barely inching up from 53.3% in 2012.) And in case you’re wondering, the proportion of equity held directly by private citizens had fallen to 12.3%, compared with 28.2% in 1981.
That’s less of a worry than it sounds if we accept that funds of one sort or another have taken up the slack. (Unit trusts owned 9.5% in 2016.) So the news that UK pension funds own barely 3% of UK equities is just a tad misleading. A better question would be whether UK investors are buying enough foreign equity exposure – given that pre-Brexit London accounts for much less than a tenth of world market capitalisation?
The growing use of derivatives is another calming aspect of the international investment scene which we ignore at our peril. Although nobody could (or should) suppose that a buoyancy vest of currency futures, warrants or whatever would provide complete protection from the likes of the 1987 crash, they do have an important role to play as shock absorbers. All of which adds a little more certainty to the situation which is especially welcome as the US president cranks up the campaign for his next four years in office.
We spoke a few minutes ago about the strong (and very welcome) growth in pension funds, which are possibly the single most important driver behind global equity prices at the moment. And which may almost entirely account for the otherwise hard-to-justify strength of US equities in particular during these fitful years of uncertainty.
But a better question would be to ask what kinds of equities these funds prefer? Lest we forget, the worldwide trend toward ethically and socially sustainable products is becoming increasingly pronounced in the retirement planning sector as, indeed, in the field of investing for children. Increasingly, too, ethically responsible funds are becoming active in holding company boards to account for their actions.
As indeed they must. According to Hargreaves Lansdown, which logged a trebling of UK ethical fund assets between 2008 and 2018, even the very largest UK funds are being pressed by their investors to keep company directors on their toes. Ireland’s sovereign wealth fund sold all of its fossil fuels last year, and every Boeing crisis or every VW dieselgate just adds to the pressure.
That’s not to say that every fund has the same objectives as its peers, however. Acceptance is now growing for US-type “socially responsible” practices – as distinct from the traditional “resist” principles favoured especially by the young in Europe. So investors are increasingly willing to accept clean-living bankers, responsible mining companies, well-intentioned GM food developers or even benevolent warplane manufacturers that wouldn’t have got a look-in five years ag
Where will it all go? I’m not sure. What I do know is that tomorrow’s investors are not fools. They are facing challenges that we boomers never had to face (although we had others), and they have better tools at their disposal than we ever did. But the political pressures of the last few years have altered the gravitational field, and with it the risk mathematics. Perhaps that’s a necessary thing, perhaps not.