Nov 26, 2014

The World is not Enough

By Panikos Teklos, Executive Director and Head of Asset Management of Beneficentia Ltd

The most accurately descriptive title, this is certainly the feeling and sentiment felt by all, from the average person in the street and the savvy professional investors, to the institutional giant, and the world’s most prominent and influential politician and policy maker.

Almost eight years since the beginning of the biggest financial crisis the world has known to date, investors still remain vague in their views on investment opportunities, and the search for sustainable yields has turned into an never-ending ordeal, while politicians and policy makers are exerting hard efforts to find the golden recipe for stabilising the financial system through a series of measures addressing growth stimulus, lowering unemployment, fighting disinflation, and regulating financial institutions and financiers with more scrutiny and vigilance. Yet, no one thus far has been able to control this metaphorical beast, which, like a Hydra from Ancient Greek mythology, is able to generate new heads every time a solution is seemingly found.

Traditional wisdom suggests that, sometimes, to solve a problem, one needs to go back to its original roots. In this case, the origin may acceptably be positioned at the uncontrolled credit growth seen through an incredibly low interest rate and compressed spreads environment between 2005 and 2007. What started off as a US subprime mortgage crisis, evolved in so many ways into a global credit crunch, a global financial crisis, and generated many questions about the principles and foundations of societies, systems and economies. A series of proven disequilibria, or at best unstable equilibria, has led to lots of continuous vicious circles, chain reactions, or “chicken and egg” situations.

Having gone through a series of unprecedented measures by the world’s central banks, fiscal and structural reforms, bank restructurings, private sector involvement schemes, or haircut on national bondholders, and even haircuts on depositors, most of the world’s economies are struggling to get back to a growth trajectory.

Granted, one would argue that austerity never facilitates growth unless feasibly accompanied by growth initiatives and stimulus for organic, esoteric growth or foreign direct investment, but lately it seems that there’s not enough in this world to get this big engine back on the roll. Living in a world that has become so convoluted in the interdependencies between politics and economics, industries and products, and structural changes and reforms make it extremely difficult to find a clean way out.

Moreover, there has been a combination of scandals surfacing on various fronts globally, an extreme tendency towards over-regulation, bank stress-tests forcing banks to become better capitalised when their NPLs are rising and lending is almost a forbidden fruit, geopolitical tensions with Ukraine and Russia have been destabilising factors for managing economic growth in a sustainable manner.

Admittedly, one of the biggest revelations to date is the differential speeds at which even the so-called “developed” economies are moving. The current themes of large budget deficits, low growth rates and deflation in Europe dominate the developed countries space, while in emerging economies, volatility of currencies, current account deficits, and capital outflows are some of the concerning factors.

One thing though continues to unite investors around the globe: the hunt for yield.

However, mood swings seem to change much more rapidly and investors’ reactions towards their holdings in risky assets show a tendency of much higher volatility. If investors “smell” that the market is going for a reversal, they try to act upon it in a much quicker way, which itself further exacerbates the market moves. The end of Q3 2014 has seen central bankers in the West starting to indicate a potential rise in interest rates for the Fed even before the end of the year given the US dollar’s 8.4% appreciation against the Euro, while the Bank of England revised their rate hike expectation for the first half of 2015. The ECB though, in a series of unprecedented measures by Mario Draghi, whose disinflation fears were growing by the day, coupled with subdued growth by some of Europe’s biggest economies, does not seem to point in that direction as of yet.

The newly introduced “Targeted Long-Term Refinancing Operations” (TLTRO) aiming to provide financing through banks towards non-financial institutions and households (not for house-mortgages) under a set of pre-defined criteria is a promising mechanism for re-starting economic activity but is still relatively untested.

Despite all of this, the amount of liquidity that is being thrown into the global financial system is unprecedented. Thus, many argue that there are deep pockets of liquidity, yet money is not being put to work. In my view, there is certainly some truth to this argument which can be justified by the increased uncertainty I analysed above. On the other hand, statistics in the market clearly indicate a lot of activity in M&A, IPOs and PE transactions.

This, of course, should not come as a surprise given the fact that large Sovereign Wealth Funds, PE and VC groups can find attractive opportunities in a whole range of projects across sectors and can certainly be the financing vehicles for certain types of privatisations of public utility companies and large infrastructure projects that would otherwise be financed by governments who are currently unable to provide this type of spending. Could this type of activity prove to be the “incentive compatible mechanism” that Information Economics would tell us can solve such problems of asymmetric information? Well, if we are to find a solution within this world then we have to start from somewhere and the common saying “Every little helps” is appropriate here. We may also need to acknowledge that what used to be called a “normal economic environment” may never be the same going forward and the outcome of this global structural change is indeed a New World Order with different attributes and certainly different standards. Once we accept this, then it will be far easier to adapt and manage expectations accordingly.

My final thought: the Chinese say, “May we live in interesting times” and, by any means, the last 7 years have been nothing but interesting and challenging for financial markets and beyond.  The road ahead is certainly not going to be a smooth straight line, but rather a bumpy ride. Adapting to this “new standard” is a pre-requisite for arriving to a stable equilibrium and finding the right balance between the various actors will take considerable coordination and collaboration.

Within our geographic region of Europe, politicians and policy makers need to start thinking about and embracing the notion of the United States of Europe. This is even more so important if the survival of the common currency is to be maintained.

Undisputedly, European countries differ massively and if decision-makers have an objective to maximise a joint objective function then they need to take into account the right constraints and recognise that the optimal solution can only be reached if each country maximises the capacity of their production within the constraints that exist in each individual case whilst having in mind the contribution towards what’s best for Europe.

They also need to work closer with the private sector and engage where possible in Public-Private Partnerships (PPPs) or other forms of Joint Venture (JV) in an attempt to reduce unemployment and restart growth. On the wealth management and advisory front, investment managers should be particularly cautious with their portfolio management strategies with ever increasing attention on their risk management systems and warning indicators.

Equally, investors should do their homework both on managers and investment opportunities with special focus on parameters such as liquidity, asset-liability management, capital protection and the use of leverage. Portfolio diversification, given initial levels of wealth, would dictate allocations across asset classes from equities, to govies, corporate bonds, select commodities such as Gold, and real assets.

The weights in these asset classes should be dynamically changing according to future projections. The other dimension worth considering is the choice of investment vehicle. Funds and managed account strategies gain increasing share and momentum as they involve specialist knowledge and expertise on such multi-strategies which are hard to follow by any single investor. Last but certainly not least, regulators across the globe should agree on following a series of standards that do not create regulatory arbitrages and also provide a robust yet realistic framework that facilitates both incentives towards investment managers and ensures investor protection. Over-regulation is certainly inferior to “smart regulation”, whereas “smart regulation” strikes the right balance between protection of the financial system and its participants and boosts economic growth.   

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