“The duration of the slump may be much more prolonged than most people are expecting and much will be changed both in our ideas and in our methods before we emerge. Not, of course, the duration of the acute phase of the slump, but that of the long, dragging conditions of semi-slump, or at least sub-normal prosperity, which may be expected to succeed the acute phase.” - The economist John Maynard Keynes, writing in 1931.
Much though it pains us to give Keynes credit for anything, in this case, he happens to have been right, roughly 80 years before the fact. Or, as the economists Rogoff and Reinhart put it, financial crises are long-drawn-out affairs and their aftermath tends to linger dangerously, for years rather than months. With trillions of government debt around the world having recently traded on a negative yield, and with deposit rates still at zero or negative across the euro zone, the “new normal” increasingly feels like a 1930s-style “distinctly unnatural”.
Facing significant but as yet somewhat intangible financial crisis, human nature is not helpful. We can only stand so much grief, and then after a sufficient period, sunny optimism kicks in, whatever the objective reality. And let’s not forget that for many equity investors, especially in the US markets, there has been no real durable crisis since 2009 – rather, one of the longest bull runs in history. Another problem facing the modern investor above and beyond the groupthink inspired by effortlessly rising markets is the mob-like status of modern communications. The Internet has given a voice to millions with nothing to say. Finding meaningful and relevant (investible) signals within the relentless barrage of cretinous noise is an ever-growing challenge.
This would seem to be the case as regards the ever-expanding sovereign debt crisis. Most governments are, to a greater or lesser extent, functionally bankrupt. And yet bond investors are still stampeding over each other to lend them more money at derisory rates. The only way to account for this seeming madness is to look at it through the prism of a crisis in money. As the financial analyst and historian Russell Napier points out, government bonds even on negative yields (e.g. those issued by Germany) make sense if the alternative is negative-yielding bank deposits that also leave you exposed as a creditor to those same banks but without any hope of a positive nominal return for incurring that risk. This problem was exacerbated by the EU’s introduction of the BRRD, the Bank Resolution and Recovery Directive, back in 2014. This time round, if you are unlucky or unwise enough to be exposed as a depositor to an insolvent EU commercial bank, they don’t get bailed out – you get bailed in. The ghoulishly inclined can see the recent history of Cypriot and Portuguese banking for further details.
How did we get into this extraordinary mess ? As we argue in the book Investing Through the Looking Glass, just about everybody played a part, but we would single out bank executives, politicians and central bankers for especial credit in the debacle. Bank executives horribly mismanaged their businesses, but rather than have those businesses painfully restructured and lose their jobs in the process, they pleaded innocence and got politicians and central bankers to bail them out instead. Central bankers then ran with the ball in a game that politicians professed to ignore (namely fiscal stimulus, as opposed to wild monetary experimentation), and brought interest rates to where they squat uncomfortably today. The free market essentially got mugged, twice.
Interest rates matter, and it matters that they are set by a free market, and not by clueless technocrats. As James Grant put it in his Interest Rate Observer of 24 June 2022:
“..interest rates are the traffic signals of a market economy. Turn them all green, as the central bankers did for years on end, and fender benders will eventually clog the intersections.
“Interest rates are prices, and prices convey information, but the thoughtful investor will be careful to weigh the caliber of information thus conveyed. Beware the data that embody the intentions of policymakers rather than the objective facts of the marketplace.
“The rate of rise in interest rates this year is the fastest I know of. For context, in the first 10 years of the great bear bond market, 1946–81, the yield on the long-dated Treasury eked out a gain of just 100 basis points, rising to 3¼% from 2¼%. I can think of three reasons, apart from market structure and positioning, to explain this upside lurch. No. 1 is the artificially low level from which it began; the familiar image of a beach ball shooting to the surface of the water comes to mind. No. 2 is the belated recognition of the persistence of a supposedly transient inflation. No. 3 is the recognition, also belated, of the tendency of clustered financial errors to store up credit risk for some future day. The view at Grant’s is that the current batch of mistakes had its origin in suppressed interest rates and that the day of reckoning is here, or just around the cyclical bend.”
We can use a more delicate phrase than an outright mugging, namely “market failure”, which puts in an appearance in Yale Endowment CIO David Swensen’s excellent guide for individual investors, Unconventional Success. The title is an allusion to Keynes’ famous observation that fund managers, courtesy of endemic groupthink, tend to prefer (and to deliver) conventional failure over unconventional success. Swensen himself is famous for steering the Yale endowment through many years of impressive investment returns. He uses “market failure” in the context of a managed fund industry that involves the interaction between sophisticated, profit-seeking providers of financial services and naive, return-seeking consumers of investment products. The drive for profits by Wall Street and the mutual fund industry overwhelms the concept of fiduciary responsibility, leading to an all too predictable outcome: except in an inconsequential number of cases where individuals succeed through unusual skill or unreliable luck, the powerful financial services industry exploits vulnerable individual investors. To Swensen,
“The ownership structure of a fund management company plays a role in determining the likelihood of investor success. Mutual fund investors face the greatest challenge with investment management companies that provide returns to public shareholders or that funnel profits to a corporate parent – situations that place the conflict between profit generation and fiduciary responsibility in high relief. When a funds management subsidiary reports to a multiline financial services company, the scope for abuse of investor capital broadens dramatically. In contrast, private for-profit investment management organizations enjoy the option of playing the role of a benevolent capitalist, mitigating the drive for profits with concern for investor returns.”
The financial crisis of 2007- ..? has taken the role of giant vampiric money-squids masquerading as investment banks to new levels of surrealism quite beyond the realm of satire. Not content with ripping the faces off clients, banks – not limited in the scope of their operations to pure investment banking – have now shown themselves quite adept at ripping the faces off taxpayers too. If deficit exists, it is not in free market terms, because as we have seen, no such free market exists. The deficit is rather a political and regulatory one. It took 10 years or so for the waves of popular anger at the banking bailouts to wash onto the shore of popular opinion, but they eventually landed all the same. First Brexit and then the election of Donald Trump were just two of the belated consequences.
The remedy, were executives and voters alike willing to behave like grown-ups, would be to return to the sort of managerial culture cited in the Hopper brothers’ magisterial study of the American economic golden age, The Puritan Gift (I.B. Tauris & Co, 2009). Such a return would largely banish consultants and supposed experts from the body politic and corporate, and reintroduce the iron concept of personal responsibility. The Hopper brothers’ Principle Seven for good corporate practice states unequivocally: one man, one boss. No sheltering amongst multiple co-heads and amongst collective (lack of) responsibility.
In The Puritan Gift, the Hopper brothers also identify the proximate cause for the crisis as
“..an excess of borrowing by government, businesses and individuals.. Increasingly, reckless lending and borrowing – two sides of the same coin – have characterized most aspects of American [and western] society for the last thirty years..
“This abuse of credit across the whole of society coincided with, and could not have occurred without, a deterioration in corporate culture occurring in the last third of the twentieth century. In the Golden Age of Management (1920 – 1970), executives had learned the craft of management “on the job” from more senior colleagues. As they progressed up the ladder of promotion, they would also absorb “domain knowledge” about the activity for which they were responsible – to borrow a term favoured by Jeff Immelt, [the now discredited] chairman and chief executive of General Electric. Starting in the late 1960s, however, a new concept appeared on the corporate scene: that management was a profession like medicine, dentistry or the law, which people were “licensed” to practise at the highest level if they had studied the subject in an academic setting. Business school graduates and accountants set the pattern of behaviour; others would follow in their footsteps. In 2001 a “professional” manager entered the Oval Office of the White House to take charge of the nation.”
Whether considering the managers of listed businesses or the managers of discretionary funds, investors should be well served by identifying those conforming to a moral as opposed to a purely self-interested approach. Decent moral behaviour is to a degree subjective, but as Justice Potter Stewart famously said of pornography, we know it when we see it. Reforming banking sector pay will only be the start of an overdue cleansing of the Augean stables. When banks compete properly for business and run the risk of genuine failure in so doing, the market will be on its way to being fixed. But as things stand, banks in collusion with central banks are distorting the term structure of debt markets (and through inflationism, all other asset markets too) and giving investors a delusional sense of safety with regard to sovereign bonds.
Both financial signals and financial signalling are all wrong. When monetary policy rates and supposedly market-led interest rates are as low as they currently are it is not a sign of confidence, but rather a reflection of absolute terror on the part of the crippled institutions that have been buying them in preference to any form of more constructive lending or investment. It is a moot point as to whether the next financial crisis is now upon us, in the form of imminent financial failures by euro zone banks and perhaps German or Italian insurers and pension funds. We would argue, rather, that the last financial crisis never got resolved in the first place. The answer, we conclude, is now to avoid paper promises by bankrupt states and institutions entirely, and to seek value in sensibly priced real assets, notably highly cash-generative but lightly indebted commodity-related companies. It’s an ill form of inflation that does nobody any good.
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: email@example.com.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
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